Beneficiary Designations-The Basics
Retirement plan beneficiary designations refer to the people you name to receive your retirement account funds when you pass. Who you choose to be your beneficiary can have several different implications, so it is important that you understand the consequences before you name your beneficiaries. In this article, we will go over the basics of what you need to know to make the best beneficiary designations for your situation
Primary and Secondary Beneficiaries
There are two main types of beneficiaries. They are primary and secondary (also known as contingent). Your primary beneficiary is the first choice of who you want to receive the account funds. The secondary beneficiary is a backup. This is who you want to inherit the account in the case that the primary beneficiary predeceases you.
You can name multiple beneficiaries in each class. If you choose to do so, you would allot the percentage of the account funds they were to receive. For example, you could name your spouse as the primary beneficiary of your IRA, giving them 100%. Then you could name your four children as secondary beneficiaries, allotting them each a 25% share. How you choose to do this may also differ for each account.
Designated Beneficiaries vs. Name Beneficiaries
There is another way to further classify beneficiaries, either as designated or named. Designated beneficiaries get preferred tax treatment and have more flexible distribution options. But they must meet certain criteria, such as the beneficiary must be an individual, not an entity and they cannot share the IRS or Retirement Plan with a non-individual.
A named beneficiary has fewer options and they do not receive preferential tax treatment. Beneficiaries fall under this category if they are entities, for example, a trust or a charity. However, under certain circumstances, a trust beneficiary can be considered a designated beneficiary. Typically, an IRA Beneficiary Trust would fall under this category.
Limitations on Beneficiary Designations
Before you name a beneficiary, it is important that you are aware of any limitations. If you name someone that falls outside of these limits it could negate your designation. This would cause the account to go to your estate upon death, possibly initiating a probate.
The most common limitation is that you cannot name your 401k’s primary beneficiary as someone other than your spouse. This is dictated by federal law and you can only get around it if your spouse signs a waiver.
In community property states, such as Arizona, IRAs also have special provisions. Even if you were to name another as your primary beneficiary, your spouse would still have the rights to the IRA funds.
Distributions After Death
How your assets are distributed after your death will differ from beneficiary to beneficiary. In most cases, distributions must begin by the end of the year following the year you die. However, your beneficiary must withdraw your Required Minimum Distribution for the year of your death if you had not already taken it.
Your beneficiaries will have different options regarding their payout periods. A payout period is the amount of time over which distributions are spread. The payout period is important because the longer the funds remain in the account, the more time they will have to benefit from tax-deferred growth. A longer payout period will also allow your beneficiaries to spread out the tax liability over several years. Typically, they can choose to take distributions over their lifetime. So, the younger your beneficiary is, the longer their payout period would be.
A surviving spouse has additional options. This includes the ability to roll over your account into their own IRA or retirement plan. This allows them to further delay distributions.
Ultimately, your beneficiaries understanding their distribution options is important. This is because distributions are subject to penalties if they are not taken in a timely manner. This penalty is 50% of the undistributed required amount for the given year. This can add up to be quite substantial.
Choosing Your Beneficiaries
Now that you understand the basics of beneficiaries you can make educated decisions for your beneficiary designations. If you are still unsure what to do, meet with a qualified financial professional who can analyze your situation and help you decide. Beneficiary designations are important components of estate planning, do not leave them to chance.
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