American retirees are set to transfer over $36 million dollars over the next 30 years – and many of them will pass along 401(k)s to their spouses and children.
Your 401(k) is one of the simplest assets to leave to your spouse, children, other family members, or an organization. However, to ensure it is a smooth transition, it’s helpful to understand what happens to your 401(k) when you die. Understanding the basics can also help you navigate state-specific laws and plan the rest of your estate.
Key Takeaways
- When you pass away, your designated beneficiary will receive your 401(k).
- You may name multiple beneficiaries and contingent beneficiaries.
- State-specific laws may govern how 401(k)s are inherited and disbursed.
To start, let’s review 401(k) beneficiaries.
What Is a 401k Beneficiary?
A 401(k) beneficiary is the person or entity you decide will inherit your 401(k) assets. You don’t need to name only one beneficiary. You can name multiple people or organizations and allocate a percentage to each one. In the event that your primary beneficiary passes away before you do, you should also name contingent beneficiaries.
You can limit yourself to one primary beneficiary, but you should always consider naming at least one contingent beneficiary. If you don’t take this step, and if your primary beneficiary dies before or at the same time you do, then your 401K will be distributed in accordance with state laws, which may not be the same distribution you would want. Take the extra step to name more than one beneficiary to ensure the funds go to the people and organizations you care most about.
How to Designate a Beneficiary
Designating a beneficiary is typically a straightforward process and can be done through your 401(k) plan’s documentation. You would not do this through your will or trust. Again, your beneficiary can be a person, business, charity, or another legal entity.
Naming your beneficiary is the quickest and easiest way to ensure the transfer of assets while avoiding the probate process.
What Happens to Your 401k if No Beneficiary Is Named?
If no beneficiary is designated, the 401(k) may go to the estate and be subject to probate – a process that can consume 10% of your assets. In this case, your will or trust might direct where the 401(k) goes, but it would be a complex and time-consuming process. Probate often adds delays to accessing funds and increases legal fees and taxes. There is also the chance, mentioned above, that your 401(k) would be distributed according to state distribution laws.
Depending on your state or employer, your 401(k) plan may automatically default to the surviving spouse without risk of probate. Many states also require that your primary beneficiary be your spouse unless he or she willingly agrees to give up that right. This may be exactly what you want to happen, but there are cases where a couple with children and/or grandchildren would prefer that a 401(k) go to the kids or grandkids and skip the surviving spouse.
It’s important to understand the default rules and what your state requires before deciding where you want your 401(k) to go.
Without a named beneficiary, the estate will have to withdraw funds within five years. This can create a significant and unnecessary tax burden while being easily avoided.
Distribution Options for Beneficiaries
Beneficiaries have different distribution options, depending on their relationship to you and how old they are. These options include taking a lump-sum distribution, rolling over the funds to an inherited IRA, or electing the life-expectancy method.
Spouses who inherit a 401(k) can take a full distribution of all the money if they wish, but they would face income taxes on the full amount of the withdrawal. On the other hand, spouses can defer withdrawals to preserve the tax protection, but ultimately, they will have to withdraw funds over several years.
The number of years depends on their age relative to the original owner. If the inheriting spouse is within 10 years of the deceased spouse, the inheriting spouse will have the longest available period to withdraw funds from the inherited 401(k). This allows them to minimize income taxes by withdrawing smaller amounts over a greater number of years.
An inheriting spouse who is more than 10 years younger than the deceased spouse must use a shorter distribution timeline. This inheriting spouse can still stretch distributions out to minimize taxes, but they have fewer years to do this than the inheriting spouse who was within 10 years of the deceased’s age.
Non-spouse beneficiaries have different rules and options for inheriting a 401(k) account. Eligible designated beneficiaries can roll over the funds to an inherited IRA, elect the life-expectancy method, or take a lump-sum distribution.
Then there are the non-eligible beneficiaries – those named to inherit your 401(k) who are more than 10 years younger than you but are not your children. These beneficiaries cannot be estates, charities, or certain trusts.
In both cases above, these annual distributions are called Required Minimum Distributions (RMDs). Spouses can withdraw more than the RMD each year, but they must at least withdraw the RMD.
While some exceptions exist, non-spouse beneficiaries are subject to a 10-year withdrawal rule. Each year, they would have an RMD, but they must also withdraw all the funds from the inherited 401(k) within 10 years of the original owner’s death.
Among the exceptions to this rule are children under the age of 10 and disabled or chronically ill beneficiaries. Each of these types of beneficiaries has special rules adapted to their unique situation.
Updating Your Beneficiaries
Life events like marriage or divorce can impact your beneficiary designations. It’s essential to review and update your beneficiaries regularly to ensure they reflect your current wishes.
If you get remarried, you need to update your beneficiaries; depending on what your previous beneficiary designations were and/or what your state’s laws require, you may find that your former spouse gets all the 401(k) or that your new spouse gets 100% and accordingly that your children receive nothing. In these remarriage situations, you still have the same rights to name your beneficiaries. Still, you need to take the time to exercise those rights by reviewing and updating, if necessary, your beneficiary designations.
Taxes on an Inherited 401k
The taxation of an inherited 401(k) is driven by the withdrawals the beneficiary makes. Inheriting a 401(k) does not cause any income taxes at the federal or state level. However, 401(k) withdrawals are taxed as regular income. If you take full and complete withdrawals from a 401(k), then that full and complete withdrawal would be taxed. But if you take a partial withdrawal or defer withdrawals into future years, then only the withdrawal in each year is taxed in that year.
Depending on the beneficiary’s relationship to the deceased, as discussed above, the amount that must be withdrawn each year differs, and therefore, so do the income taxes.
Most beneficiaries, regardless of their relationship to the deceased, usually try to postpone income taxes by stringing out withdrawals over future years. This is easier for spouse beneficiaries than non-spouse beneficiaries because spouse beneficiaries have the smallest RMDs.
Beneficiaries subject to the 10-year rule should be careful that they don’t leave too much money in the inherited 401(k) in the 10th year. At the end of the 10th year, the entire remaining balance must be withdrawn, and that entire withdrawal would be taxable. It is entirely possible that this potentially large 10th-year withdrawal would push you into a higher income tax bracket that year.
Proper tax planning can avoid this, and we advise using a 100% objective fiduciary advisor to help you with this analysis.
Special Considerations for Surviving Spouses
A surviving spouse can merge the deceased spouse’s 401(k) with their own retirement plan or into a newly-created inherited IRA. They also have the option to use the ten-year rule, depleting the entire 401(k) over a ten-year period.
Taking a lump-sum distribution of the deceased spouse’s retirement fund is also an option, even though it will result in a higher tax burden.
State-Specific 401k Inheritance Laws
Some states require spousal consent if a non-spouse is named as the primary beneficiary. The Employee Retirement Income Security Act (ERISA) overrides state laws for most employer-sponsored 401(k) plans, ensuring spousal rights in inheritance. As of this writing, the states requiring spousal consent are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
State laws regarding creditor protection and probate distribution laws for inherited 401(k) accounts also vary. For this reason, we again recommend you work with a fiduciary advisor and a lawyer who knows your state laws in and out when designating beneficiaries.
Estate Planning Tips for Your 401k
Regularly review your 401(k) beneficiary designations to reflect life changes and tax implications of your designations.
Consider using a per stirpes beneficiary to distribute your 401(k) equally among your children.
You will also want to avoid naming your estate as a beneficiary, as this can lead to probate and potentially income taxes immediately after your death.
Ensure your beneficiary designations are consistent with your will and other estate planning documents. There’s nothing worse than leaving your family with a contradiction in the documents. If one says the wife gets the 401(k), and another document says a child gets it, this can cause family friction and, in some cases, a lawsuit among family members.
What Is A Per Stirpes Designation?
A per stirpes, meaning “by the roots,” designation allows you to distribute your 401(k) equally among your children, even if one of them passes away before you do. This can help ensure that your grandchildren receive the inheritance intended for their parents.
Per stirpes designations can be used to distribute assets among multiple generations. It’s essential to review and update your beneficiary designations regularly to ensure they reflect your current wishes.
Alternatives If You Want More Control Over Distribution
Directly leaving your 401(k) for an inheritance isn’t the only way to provide for your loved ones. Some additional ways you can weave your 401(k) into your estate planning include:
- Roth 401(k) Conversions: Converting to a Roth IRA before death can reduce the tax burden for beneficiaries.
- Stretch IRA Strategy: For eligible designated beneficiaries, rolling over the 401(k) into an inherited IRA can help stretch distributions over a lifetime.
- Trusts: While trusts are not the easiest way to leave a 401(k), you can use them to manage how and when beneficiaries access 401(k) funds. In this case, the trust must be written with special language to handle the 401(k).
- Charitable Remainder Trusts (CRTs): This option allows a portion of the 401(k) to go to charity while providing income for heirs.
Integrate Your 401k Into Your Estate Planning
Whether you are leaving a 401(k) or inheriting one, it’s critical to understand that each choice can have a significant financial impact. Regulations are specific to the original account owner’s relationship with the beneficiary, their age, and whether the beneficiary hit their Required Beginning Date (RBD).
The process can be straightforward, but the distribution details can quickly make things confusing. Consider speaking with a fiduciary financial advisor to ensure you fully understand the 401(k) inheritance process, and discover how to integrate your 401(k) into your full estate plan.
Book a complimentary consultation with our objective, fiduciary advisors today.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
