Retirement account beneficiary guide for IRAs and 401(k) plans

Whether you've selected beneficiaries recently or some time ago for your 401(k) and individual retirement account, or IRA, it's a good idea to periodically review your choices to be sure your assets will be disbursed according to your wishes.

Choosing beneficiaries for retirement accounts is different from selecting beneficiaries for other assets distributed via your will, like personal property. Not properly designating retirement accounts may lead to unintended issues after your death.

The importance of beneficiaries

For example, let's say Marci, who is executor of her mother's estate, discovered after her mother passed away that several of her mother's retirement accounts had incomplete beneficiary designations. In some instances, Marci was the only beneficiary, excluding her brother David. As executor, she was faced with trying to balance the inheritance between David and herself—and was required to go through probate for the accounts without designated beneficiaries.

Most retirement accounts are also taxable as income to the beneficiary, so it's important to know the effect income tax and estate tax laws may have when making beneficiary selections. Although this consideration shouldn't be the sole determining factor in naming beneficiaries, ignoring the impact of taxes on your loved ones is another issue that may lead to unintended consequences.

What is a beneficiary for a retirement account?

For accounts like IRAs and 401(k)s, the beneficiary is the recipient of your account assets after your death. Recipients may be individuals or legal entities, such as trusts, that are established to allow your assets to be distributed as you see fit—and provide maximum value after taxes.

Consider these four key factors when naming your retirement account beneficiaries.

1Beneficiaries pay income tax on most retirement account distributions

Most inherited assets like bank accounts, stocks and real estate pass to your beneficiaries income tax-free. However, this isn't the case with pretax-contributed 401(k) plans and IRAs.

Beneficiaries will pay ordinary income tax on distributions they may receive from pretax 401(k) accounts and traditional IRAs. Roth IRAs and Roth 401(k) accounts, which are generally funded with after-tax contributions, are distributed to beneficiaries tax-free if all requirements are met.

For example, let's say Ellen left her traditional 401(k) valued at $100,000 to her first child, Taylor, and her $100,000 Roth IRA to her second child, Payton. Taylor is in a 28% tax bracket, giving them an after-tax inheritance of $72,000. Because distributions from Roth IRAs are income tax-free, Payton's net inheritance from Ellen's IRA is $100,000. Ellen's beneficiary selections unintentionally created an inequitable inheritance among her two children. Unfortunately, mistakes like these are common and may generate resentment and estrangement among heirs.

Changes to distribution timeline

You should also be aware that the timeline for distributing the account assets to your beneficiaries has changed. In the past, your beneficiary could spread the payments out over their own life expectancy, continuing the benefit of income tax deferral. This rule changed as of January 2020. Now nonspousal beneficiaries—save for a few exceptions—are required to complete all distributions from the account within 10 years.

2You can name or update beneficiaries at any time

When you open an IRA or begin participating in a 401(k), you'll be asked to name beneficiaries either electronically during account setup or via a separate form. If you decide to change beneficiaries, you can do so electronically through your online account or by completing a new beneficiary designation form. However, it's wise to consult an advisor before making a beneficiary change.

Naming retirement account beneficiaries is important because retirement account distributions don't follow the directions provided in your will. And if you made a mistake, such as naming an ex-spouse, a court can't amend the designation after your death like it could with a will.

Retirement accounts are often a large part of someone's net estate and play an important role in estate planning, so it's critical to seek legal and tax guidance when making decisions about them. In the example above, Ellen could have easily corrected the inequitable distribution of her two retirement accounts to Taylor and Payton prior to her death by consulting tax advisors.

It's a good idea to link the review of your beneficiary forms with a financial activity you already do every year, like renewing your property insurance or completing your tax returns.

Also be thoughtful about which beneficiaries you choose because inherited IRAs or qualified plans don't enjoy the same level of creditor protection given to the original participant. Such accounts also fall outside your will or trust's protections. If you have a beneficiary who's more exposed to litigation or other creditor issues, you may want to divide your assets so the beneficiary receives most of their inheritance from trust assets—where you can set the level of asset protection provided—while your other beneficiaries receive the qualified plan.

3You can designate primary and secondary beneficiaries

When considering who to name as beneficiaries on your retirement accounts, be sure there are no gaps. Your primary beneficiary is your first choice to receive your retirement accounts. However, you can name more than one person, trust or charity as your primary beneficiary.

A gap could occur if your primary beneficiary doesn't survive you, is ineligible or disclaims the benefits. In these cases, your secondary—or contingent—beneficiaries would receive the retirement benefits. If there's no contingent beneficiary named, the benefits of these retirement accounts would pass to your general estate, which could cause a loss of tax advantages or other issues.

If your estate receives your retirement accounts, the opportunity to maximize tax deferral by spreading distributions over 10 years may be reduced to 5 years if you hadn't started required minimum distributions, or RMDs. In addition, it may require probate, which can involve paying attorney and executor fees and delaying the distribution of benefits.

If you choose to name multiple beneficiaries as either your primary or contingent beneficiaries on a retirement account, be sure to specify the percentage each should receive and ensure that the total of each primary or contingent's bequest equals 100%.

As you look at your accounts with beneficiary designations—as well as any inherited assets from trusts or wills—consider their total value to determine if there are any unanticipated inequalities like Ellen experienced.

4Know the types of beneficiaries you can name on retirement accounts

You have several 401(k) beneficiary options when planning how your retirement accounts will transfer.

Naming your spouse as a beneficiary

From a tax planning perspective, naming your spouse as a 401(k) beneficiary on your retirement accounts gives them the greatest flexibility.

For example, if your spouse is 59 1/2 or younger, they'd be able to access retirement funds without being penalized for an early withdrawal. Your spouse could also elect to treat the retirement accounts as their own and roll the retirement account into an IRA under their own name. This would allow them to use their own age to follow required RMD rules.

Although the surviving spouse will still have to consider the impact of income taxes on applicable distributions, if they're older than 73 and are charitably inclined they can alleviate some of this tax burden through a qualified charitable distribution. The IRS offers a helpful list of requirements for charitable contributions.

Naming other individuals as beneficiaries

If you're married, you may have some limits on choosing individual beneficiaries other than your spouse. In certain states, federal law dictates that your surviving spouse be the primary beneficiary of your 401(k) benefit unless they sign a timely, effective written waiver. If you live in a community property state, your spouse may have rights related to your IRA regardless of whether they're named as the primary beneficiary.

Keep in mind that a nonspouse beneficiary can't roll your 401(k) or IRA into their own IRA to treat it as their own, but they can choose to move the retirement accounts into an inherited IRA. Even so, with the SECURE Act most nonspouse beneficiaries may fall under the 10-year rule in which the inherited IRA will need to be distributed and closed by the end of the tenth year after death.

Because distributions from IRAs are taxed at the beneficiary's ordinary rate, it's important to prepare a tax projection for yearly RMDs to give the beneficiary some idea of the impact of the distribution on their taxes. Additional taxable income may move the beneficiary into a higher tax bracket and possibly subject them to net investment income tax of another 3.8%. To account for the additional tax liability, the beneficiary may want to consider having tax withheld from the distributions or make quarterly estimated tax payments.

Naming a trust as a beneficiary

If you choose to name a trust as the beneficiary of your retirement accounts, there are special rules to ensure the proper path of the retirement account to your trust and avoid other income tax complications.

For example, if a trust is named as a beneficiary of an IRA and it doesn't qualify as a see-through trust under IRS rules, the IRA must be distributed within 5 years, and any taxes owed will be accelerated. Be sure to seek legal advice and understand all of the ramifications before designating a trust as a beneficiary.

Naming a charity as a beneficiary

If you don't have a spouse, other individual beneficiaries or trusts you'd like to name as primary or contingent beneficiaries on your retirement accounts, you can choose a charity whose mission you support.

By naming a charity, the organization wouldn't receive any of the tax-deferral benefits individuals or possibly a trust would receive, but they'd receive the immediate benefit of using the funds from your retirement accounts to further the philanthropic missions you care about. Because charities are tax-exempt entities, they can withdraw assets from the retirement account income tax-free. Due to this benefit, many people choose to leave some or all their qualified assets to charity and leave their remaining income tax-free estate assets to beneficiaries.

The bottom line

When developing and reviewing your estate plan, it's important to consider how all assets and accounts—including your retirement accounts—will be distributed. By speaking openly with financial, tax and legal professionals about your estate planning goals, you can feel secure that your designated beneficiaries will benefit in the way you intend.

Review our Retirement Plan Distribution Alternatives and Considerations (PDF) resource for more help with retirement plan beneficiaries and distribution options.

To start the conversation about your financial estate plan, get in touch with a First Citizens Wealth consultant.

Key takeaways

• Most inherited assets like bank accounts, stocks and real estate pass to your beneficiaries income tax-free. However, this isn't the case with pretax-contributed 401(k) plans and IRAs.
• Retirement account distributions don't follow the directions provided in your will, so it's important to name your retirement account beneficiaries.
• To feel secure that your designated beneficiaries will benefit in the way you intend, discuss your IRA and 401(k) beneficiary selections with your financial team.