401(k) beneficiary rules: What you must know

DES MOINES, Iowa (AP) — Most 401(k) investors are worried about whether they’ll outlive their savings and haven’t given much thought to the opposite scenario.

This can be a big mistake because there are inheritance rules that may require your account to be distributed in a way that you didn’t foresee.

So for starters, confirm who is listed as the beneficiary of your account. You should have filled out a beneficiary form when you opened the account, but it’s a good idea to reevaluate it periodically. It’s especially important if you’re recently divorced or experienced other life changes that would prompt you to rethink your choices.

What’s more, you’ll want to understand the tax implications for those you leave behind.

Who gets the money

One of the most common financial planning mistakes is forgetting to change beneficiaries after a divorce or when someone remarries, said Dean Kohmann, a vice president at Charles Schwab Corp.

It’s not enough to specify in a will that you want someone else to inherit your 401(k). As with insurance policies, certain retirement account funds are paid directly to beneficiaries regardless of wills.

What’s more, if you’re married a federal law says a surviving spouse is automatically the beneficiary of 401(k) funds. To leave the money to someone other than your spouse, that person must be named on a beneficiary form, and your spouse must sign a waiver relinquishing any right to the money.

Kohmann, tells a story of a client who at 70 remarried a much younger woman. The man had three adult children to whom he wanted to leave the $1.6 million in his retirement account. The three children were named as beneficiaries, however, the new wife had never signed a waiver. She received the entire amount.

“Five minutes of planning can prevent years of heartache and family squabbles among the people you love the most,” Kohmann said.

If you’re single and you don’t fill out a beneficiary form, the retirement plan rules may dictate who gets the money. It could end up in your estate, which means it will be tied up in a legal process before distribution to heirs.

On your account you’ll be able to list both a primary and a contingent beneficiary. It’s important that you name a contingent beneficiary because if your primary beneficiary dies before you do, your account balance may pass to your estate.

How taxes are handled

A surviving spouse will be able to rollover the funds into an IRA without incurring any taxes or penalties. A key benefit is that the spouse can continue to enjoy compounded earnings and won’t have to start withdrawing money until age 70½, when the IRS required minimum distribution rules kick in.

The spouse can also choose to put the money in a new account called an inherited IRA — which would be set up in the 401(k) account holder’s name with the recipient as beneficiary. The recipient must take the first minimum distribution to be withdrawn a year after the account holder’s death. The distributions would be taxed but there would be no early withdrawal penalty.

Anyone other than a spouse receiving 401(k) funds cannot transfer funds into an existing IRA. Instead they should set up a new inherited IRA to avoid tax penalties or forced cashing out of the account. The recipient can leave the money in the IRA to continue to grow tax free, withdrawing only the minimum amount required by the IRS.

How to leave your account to the children

If your spouse doesn’t need the money, there may be advantages to leaving the account to younger members of the family. Younger heirs will be able to stretch the value of the account further.

The IRS requires recipients to take minimum distributions out of the account, usually the year after the death of the deceased, but bases those payments on the life expectancy of the recipient. A younger person would have more years in which to stretch out the payments, allowing the account to grow tax-free for longer. Very large accounts may be stretched out over the lifetimes of children and grandchildren.

How to consider multiple beneficiaries

When weighing what to leave your children, you should know the Latin phrase “per stirpes” which is used more frequently on retirement account beneficiary forms.

It means “by branches” and it’s a good way to make sure your funds are distributed among family members following a succession of parents to children to grandchildren, said Jeremy Welther, a senior financial adviser for Brinton Eaton Wealth Advisors in Morristown, N.J.

Let’s say you want to leave your spouse as the primary beneficiary, but you want the money to automatically go equally to your three children if your spouse also dies. If you name your spouse per stirpes, the money would flow equally to the children. Let’s say you have grandchildren, too. If one of the children happened to die, that child’s share of the money would then flow to that person’s children equally.

It’s an easy way to establish primary and contingent beneficiaries.

Be sure to tell someone in your family your plans for leaving your retirement money. Keep beneficiary forms in a safe place and tell someone you trust where they can be found.

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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7 Responses to 401(k) beneficiary rules: What you must know

  1. Joe B. says:

    How can I email this info. to myself?

  2. Phil A. says:

    Our daughter has a daughter and an also a stepdaughter (her husbands child). If the term “per stirpes” is used for the beneficiary, is the stepdaughter included in the branches?

  3. Whitney says:

    Does the beneficiary have to be a resident of the U.S.?

  4. EJ says:

    @ Phil A: “Step” relations are for almost NEVER considered heirs under the law. I say almost, because in the case where a step parent legally adopts the step child, some states will recognize the step child as an heir, and others will not. To be safe, anyone with children from anything other than direct birth needs to specifically name the child as a beneficiary on their accounts and in their will.

  5. MJ says:

    I have a touchy case. My father wants to switch his IRA with me (only son) as beneficiary. It was originally listed with my mother as beny. She died and he switched it to me…he remarried within the year and was coerced into switching it to the new spouse. Would this require a consent form? The state in question is New Jersey.

  6. MJ says:

    Just a little more info. The bank in question (TD) swears there is no need for consent or notice. Lawyers are telling us otherwise so I’d love to get a straight answer.

  7. lisa p. says:

    i have a question my daughter is the first child of her father and he did not put her on his 401k but put the second child and his old girlfriend. my daughter got a letter from the old girlfriend stateing they were never married. is there a way if my daughter proves that she is the daughter of this man that she can be part of the 401k what is the steps she has to do to split the money between her and her brother