Be Smart in Naming Beneficiaries of Your 401(k)

Don't let your legacy become a nightmare for your family

It's common when a person works in the same company for a long time for the dusty 401(k) paperwork to sit in a file drawer safe and sound—and out of date.

Imagine the shock when the death of a happily married executive, the proud parent of several children with a second wife, reveals that the primary, 100% beneficiary of his 401(k) is his first wife. Wife number two will have to sue and hope that the courts will correct this mistake, but her chances of getting more than 50% are poor at best.

In the flurry of decisions that come with a new job, it's easy to give short shrift to choosing beneficiaries on various financial accounts. For one thing, this task makes people think, at least briefly, about their own death. Think instead about the bequests as gifts to the people who should receive them.

These designations are important to get right. Otherwise, a legacy may become a nightmare.

Key Takeaways

  • You must name a primary beneficiary and at least one contingent beneficiary (to whom assets will pass if the primary beneficiary has already died).
  • Beneficiary designations for 401(k)s override the contents of a will.
  • Children who are still minors cannot inherit as direct beneficiaries.

Beneficiary Designation and Allocation

When you set up a company 401(k), you're faced with a beneficiary form that asks for both the primary and the contingent beneficiary or beneficiaries. If you should die with that 401(k) still undesignated, it will end up in probate court—no place to leave grieving loved ones.

You must name a primary beneficiary and at least one contingent beneficiary (to whom assets will pass if the primary beneficiary has already died). Once the assets have become the property of the primary beneficiary, the backup beneficiary loses all claims.

This assumes that one-hundred percent of the assets go to the primary beneficiary. You may choose instead to name several primary beneficiaries, allocating percentages of the assets to them. If, for instance, a spouse will already be well provided for, the asset owner might decide to allocate only 50% of the 401(k) to them and divide the rest between the couple's two children as 25% primary beneficiaries each.

For any account governed by the Employee Retirement Income Security Act (ERISA), putting a spouse down for less than 50% triggers the need for a spousal waiver. This provision is in the state's interest so that the widow or widower will not be left indigent while all assets go directly to the children—or someone else. It can head off litigation, too.

Again, multiple contingent beneficiaries, like multiple primaries, may be allocated percentages. One might designate 100% for the spouse as the primary beneficiary, and then in the backup allocation (contingency), divide equally among one's children.

Think of these decisions as part of an overall estate plan. Just proclaiming that "all my assets to be divided equally between" or some such language in a will doesn't automatically take care of everything. Beneficiary designations for 401(k)s override the contents of a will, and any conflicting naming of heirs opens the door to litigation that wastes money and may create a legacy of antagonism in the family.

How Old Are the Kids?

Children who are still minors cannot inherit as direct beneficiaries; a guardian must be provided to oversee the use of the funds (or the court will appoint one). If possible, avoid the involvement of the surrogate court, which hears cases involving the affairs of decedents, including the probate of wills and the administration of estates and trusts.

Setting up a trust in the children's names with a trustee of choice is often a solution. Doing this (with the help of an attorney or similarly qualified expert) also allows for specifying how old the children have to be to come into their inheritance.

With an attorney, one may want to explore establishing a testamentary trust that can be named as a beneficiary. In a testamentary trust, the trustee manages the assets until the trust expires and the beneficiary receives control of them.

The expiration date of a testamentary trust is usually tied to a specific event, such as the beneficiary reaching a certain age.

With individual retirement accounts, there are enough tax complexities according to the type of account and the life situation of heirs for professional tax planning or legal expertise to be brought in. This helps avoid unnecessary taxes, and it allows the beneficiaries future flexibility in how they withdraw the funds.

These concerns also hold for other funds that might pass to children. As with 401(k)s, life insurance payouts cannot go directly to young children, who must be 18 or older to receive the funds directly. The Uniform Transfers to Minors Act (UTMA) governs in most states. A designated custodian will manage the assets until the children are old enough to take over. 

Review and Update

Review beneficiary decisions at least annually and whenever life changes in a major way: marriage, divorce, the death of a parent, the birth of a child, or the sale or acquisition of major assets.

The deceased's estate should never be the beneficiary of a 401(k). To do that, either on purpose or simply by failing to name a beneficiary, means the 401(k) money will be disposed of by probate court, which may also delay the distribution of assets to heirs for months.

The Bottom Line

Who inherits an asset like a 401(k) is a momentous decision—and a critical detail often handled once and then forgotten. Realize the importance of those names on the dotted line and remember to inspect them at least once a year. To learn how various beneficiaries and their life situations may affect designation decisions, consult an estate-planning specialist or tax expert.

Article Sources
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  1. U.S. Department of Labor. "FAQs About Retirement Plans and ERISA," Page 8.

  2. New York University Law Review. "Accidental Inheritance: Retirement Accounts and the Hidden Law of Succession," Pages 167-169.

  3. Uniform Law Commission. "Transfers to Minors Act."

  4. Social Security Administration. "Program Operations Manual Systems (POMS): SI 01120. 205, Uniform Transfers to Minors Act."

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