If you think a will or trust will ensure that your 401(k) assets go to the person you want after your death, think again. The beneficiaries you list on these accounts will take precedence over any will or trust. That means that if you're not careful, a big chunk of your savings could be given out in a way you don't intend.
To ensure your estate is settled in the way you want, it's wise to do a bit of extra planning to keep your documents up to date.
After a person's death, their full taxable estate is handled by probate, which can be an expensive and time-consuming process. That said, 401(k) plans that list beneficiaries usually bypass probate, going directly to the beneficiaries instead.
When you set up your 401(k), you are often asked to set a beneficiary in your paperwork, that being someone to whom these funds will transfer after your death. This can be a person (usually your spouse, child, or domestic partner) or a trust (a third party that manages your assets for the benefit of beneficiaries).
If no beneficiary is listed and the owner was married, 401(k) plans designate the owner's spouse as the default beneficiary. The account owner's spouse can treat the inherited account as their own. That means spouses can delay withdrawing money from these accounts until they reach 72 years old, which is when the IRS' required minimum distributions start. They can use their own life expectancy when calculating future withdrawals.
Listed beneficiaries other than a spouse will have the assets put into an inherited 401(k). The amounts received are dictated by the percentages listed on the beneficiary designation form. Most plans will offer beneficiaries the ability to roll over an inherited 401(k) into an inherited IRA. That will give the account holders greater control over how they invest their inheritance.
Once you've chosen your main beneficiary, it's wise also to list contingent beneficiaries. Contingent beneficiaries will inherit the trust if the primary beneficiary is deceased. Usually it's best to make a trust or children contingent beneficiaries if your primary beneficiary is your spouse -- but keep in mind that listing a trust as a beneficiary can be a costly decision at tax time, so you'll want to consult with your tax attorney first.
Avoid these 401(k) beneficiary mistakes
As you can imagine, the list of mistakes people make when naming beneficiaries can be quite long:
- Setting up a trust to keep IRA or 401(k) assets from going to a minor (or a spendthrift of any age), or to protect services for a special-needs child, and then failing to list the trust as a beneficiary.
- Naming no one as a beneficiary on an IRA or 401(k) plan.
- Not updating beneficiaries after important life changes.
You might think establishing a trust allows you to skip the beneficiary section of your 401(k) plan, but that's not the case. If you don't specifically list the trust as beneficiary, accounts will pass directly to any person listed as a beneficiary or they'll end up in probate.
Leaving the beneficiary section blank can be disastrous, particularly if you don't have a spouse or want your money to go to someone other than your spouse. Your accounts will then enter your estate and go through probate, which will significantly crimp heirs' ability to make the most of inherited 401(k) tax rules.
A beneficiary has 10 years to draw down an inherited 401(k) or inherited IRA. By comparison, the IRS mandates that assets held in accounts that wind up in an estate be drawn down within five years of the account owner's death.
It's important to remember to update your beneficiaries after important life events as well. If you have children, if you get divorced or remarry, or if you outlive your original beneficiary, you'll likely want to review your beneficiaries.
What else should I know?
Career changes can leave you with multiple accounts, and that can make tracking beneficiaries tough. It may make more sense to consolidate your accounts into one so that it's simpler to make sure your beneficiaries are up to date. Consolidating also makes it easier for your heirs to set up an inherited 401(k) after your death, and it reduces the risk that an account will be forgotten.
If you do list a trust as your beneficiary, make sure the trust's language takes into consideration how taxes will be handled. If the trust isn't designed as a conduit or see-through trust, then the IRS will tax required minimum distributions from these accounts at the trust's tax rate, not the beneficiaries' tax rate. In 2020, trust tax rates climb to 37% after just $12,950 in income.
Also, after you've set up your beneficiaries, make sure your beneficiaries have updated their beneficiaries, too. If you leave your assets to your spouse and they pass away without beneficiaries, these accounts can still end up in probate despite your efforts.