Your 401(k) is a big part of your retirement portfolio. While advisors do much of the “behind the scenes” work to make sure your investments grow, you have the power to decide one of the most important aspects of your 401(k) – your beneficiary designation (i.e. who inherits the remainder). 401(k) accounts have beneficiary designations which make them “non-probate property”. That means they pass by contract (i.e. your beneficiary designation form) and not through your Will. Therefore, choosing your beneficiary is an important component of your 401(k), and these helpful pieces of advice can help you make the best decision for your 401(k).
1. Naming Your Spouse as Primary Beneficiary
Often times your spouse is your first, best, and most logical choice as beneficiary. There are a number of reasons, both practical and legal, why choosing your spouse as your 401(k) beneficiary makes good sense.
A. Electing Your Spouse Maximizes Tax Savings and Helps Ensure Their Well-being
There are many good reasons to elect your spouse as your 401(k) beneficiary. The most obvious reason is to ensure they are well protected for their entire life. Unlike other beneficiaries, your spouse has the ability to roll your 401(k) benefit over into an IRA. This will prolong the tax savings that make a 401(k) so special in the first place, and will also help the investment further grow over time. Additionally, electing your spouse as your 401(k) beneficiary allows them to decide how to pass these assets to your children and grandchildren in a way they know you would want.
B. You May Not Even Have a Choice
Most people have a 401(k) that is covered under the Employee Retirement Income Security Act, or ERISA. ERISA is a federal law, and the Georgia Supreme Court has explicitly ruled that ERISA preempts all state laws related to employee benefit plans Under ERISA, unless your spouse waives their right to the 401(k), your surviving spouse will always have a right to a portion of your 401(k). This is true even if you name another person as your beneficiary. This waiver requires your spouse to agree in writing they will not have a claim against your 401(k) and requires a plan representative or notary public to be present when the waiver is signed. Even after your spouse signs the waiver, they will still be required to consent to any 401(k) beneficiary you choose, and also need to consent to any changes to the 401(k) beneficiary you may make in the future.
2. Another Individual as Primary Beneficiary
If you are unmarried when you fill out your beneficiary designation form, you can choose an individual, entity, or your estate to be the primary beneficiary of your 401(k). If you get married after you sign your beneficiary designation form, ERISA will require your new spouse become the primary beneficiary, unless they have signed a valid waiver. If you divorce your spouse while they are your beneficiary, you will generally apportion the percentages of 401(k) ownership in your divorce agreement. Subsequent marriages and divorces will further complicate matters, so seeking tax and legal advice may be beneficial.
3. Name An Individual as Contingent Beneficiary
You can name anyone you like as a contingent beneficiary, and you may do so without your spouse’s consent. Naming an individual, rather than your estate, can make good practical and tax sense for several reasons. The first benefit of naming an individual as contingent beneficiary, rather than your estate, is the ability for that beneficiary to maximize the tax savings from your 401(k). Unlike your spouse, they will not be able to roll the account into their own IRA, potentially drawing out even further tax benefits. Non-spouse individual beneficiaries may, however, allow the 401(k) to continue, take a lump sum disbursement, or take a distribution based on their life expectancy under certain circumstances. Your beneficiary will elect option that is right for them based on their need and their desire to avoid tax consequences.
If, however, you name your estate as the beneficiary (or fail to have either a primary or contingent beneficiary) these potential tax savings and deferments vanish. If your 401(k) becomes part of your estate, the funds must be liquidated and disbursed within 5 years, much shorter than the life expectancy of most individual beneficiaries. Another problem with 401(k) distributions is the tax consequence. Disbursements into a 401(k) are not taxed, and build up tax free. Disbursements from a 401(k) are taxed, so many people stretch out the disbursement period to minimize the tax consequences. In general, the longer the funds remain in your 401(k), the smaller the yearly tax consequences will be. Therefore, unless you have no beneficiaries you would want to take your 401(k) or have no beneficiaries with life expectancies longer than 5 years, it is best to name an individual as beneficiary to maximize your gift.
4. Naming a Trust as Beneficiary
Naming a trust as beneficiary can be beneficial, but it is an intricate process that requires good estate planning to carry out. 401(k)s are meant to give disbursements over the lifetime of the beneficiary. There are minimum amounts that must be disbursed each year, known as “minimum required disbursements” that are calculated based on the beneficiary’s life expectancy. A trust is not a person, and has no life expectancy. Thus, unless drafted properly, 401(k) funds placed in trust will require full distribution within 5 years.
So called “look through trusts” permit a longer disbursement period based on the trust beneficiary’s expected lifetime. These trusts are complex, but the basic requirements demand they be irrevocable, the beneficiaries must be able to be clearly identified by the terms of the trust, the trust must not violate state law, and a copy must be furnished to your plan coordinator. Additionally, if a non-individual entity (such as a charity, church, or company) is named as a beneficiary, the “look through” trust will fail, and 401(k) benefit disbursements must be made within 5 years.
Patrick R. Norris, J.D., Norris Legal, L.L.C.
Thank you for reading this article. The information contained in this article is for discussion purposes only. The information contained in this article is not legal advice upon which you should act and simply reading this article does not make you a client of Norris Legal, L.L.C. or any other law firm. Thank you again.