When thinking about retirement funds, you’re probably most worried about having enough money to live comfortably. What people often forget to plan for – quite understandably – is their eventual passing. For the sake of your spouse or other family members, make sure things are set up correctly. It’s not enough to just make the money; you have to protect it as well – and ensure it gets into the right hands after your death.
"Retirement accounts with ill-conceived beneficiary designations could potentially cost your family tens of thousands or even hundreds of thousands of dollars if done wrong," says Dan Stewart, CFA®, president, Revere Asset Management, Inc., Dallas, Texas. "Correct beneficiary designations are crucial for retirement plans, and there are a lot of pitfalls and mines to avoid when naming both the primary(s) and contingent beneficiary(s). To avoid penalties and taxes, you really need to seek counsel from a competent advisor fluent in estate planning."
IRAs generally are not covered in your will. So, when you open an IRA, you should complete a beneficiary designation form. This form names the person or persons who will receive your IRA and in what proportions. You can amend the form at any time, but whoever is on the form upon your death will receive the funds – even if they are an ex-spouse or a disinherited child.
"If you name multiple people as beneficiaries of one retirement plan, they all take required minimum distributions (RMDs) based on the life expectancy of the eldest beneficiary (I.e. the person who has to take out the largest distributions). Better to split up assets over several plans with each beneficiary being the recipient of his or her own Inherited IRA," says estate attorney Daniel Timins, CFP®, Law Offices of Daniel Timins, New York, N.Y.
Your beneficiary has five options:
- Keep the inherited IRA: This is a good option if the deceased had already started taking required minimum distributions (RMDs) from the account. As a bequest, it allows your beneficiary to withdraw those funds too, even if he or she is younger than age 59½, without having to pay the usual 10% early withdrawal penalty. The RMDs continue to be based on the deceased person’s age rather than the beneficiary's unless the beneficiary submits a new schedule, based on his or her age. Important: If the IRA you inherit is a Roth, you have to take RMDs even though the deceased wasn't required to take them; rules are different for beneficiaries than for participants. These withdrawals may be subject to income taxes. (For more, see The Rules on RMDs for IRA Beneficiaries.)
- Roll over the IRA: Take the assets and roll them into in a personal IRA – either a new one or a pre-existing one – without paying income tax or early-withdrawal penalties (unless you are under age 59½ when you take a distribution). If you roll over an inherited Roth IRA, you do not pay penalties if the assets have been in the account for five years. This rollover option is only open to a surviving spouse, and he or she must transfer to the same account type – traditional IRA to a traditional IRA or Roth IRA to a Roth IRA. "If the spouse rolls it into their personal IRA, they can update the beneficiaries and put off taking RMDs if they are less than 70½ years old," says Scott A. Bishop, CPA, PFS, CFP®, partner and executive vice president of financial planning at STA Wealth Management, Houston, Texas.
- Convert to a Roth IRA: If you anticipate being in a higher tax bracket later in life, it might be advantageous to convert a traditional IRA into a new Roth IRA account. Be aware that you will pay all applicable income taxes at this time, but down the road, you won't owe any more taxes or have to take RMDs.
- Disclaim all or part of the assets: Basically, this means that you give up any and all claim to the funds, which then go to the other beneficiaries mentioned in the designation form.
- Take the money: Cash out the IRA. If you’re younger than 59½, a 10% early withdrawal penalty may apply. You will pay all applicable taxes at that time and it may push you into a higher tax bracket. If the IRA is sizable, speak to a financial advisor about tax-efficient ways to cash out.
Things are slightly different with your 401(k). You will still complete a form that designates who will receive your benefits when you pass away. However, if you’re married, the law says that your spouse will receive the account. Even if you’ve been legally separated for years and now live with somebody else, your spouse is entitled to the account upon your death. The only way that can change is if your spouse signs a document giving up his or her rights as a beneficiary. Divorce settlements generally include provisions for whether ex-spouses are entitled to any 401(k) money, in keeping with the rules of each spouse's plan.
“Always update your employer 401(k) beneficiary designation paperwork immediately after a divorce to reflect the intended beneficiary and consult an estate planning attorney to ensure your intended wishes will be carried out at your death – especially if you have remarried – to avoid future conflict. Otherwise, your ex-spouse may get something that was not agreed upon," says Michelle Buonincontri, CFP®, CDFA™, a financial planner with Being Mindful in Divorce, Scottsdale, Az.
If you’re single, the people named on your beneficiary form receive the account.
The recipient’s options with a 401(k) are basically the same as with an IRA: Keep it, roll it over somehow, cash it out or decline to receive it.
Any time the topics of assets and death arise, the subject of estate taxes should come up. If you were to pass away in 2017, your beneficiaries won’t be affected by federal taxes if the total value of your estate is $5,490,000 or less.
If it exceeds that amount, talk to an estate lawyer or tax attorney as soon as possible to discuss strategies for legally sheltering assets. It may involve strategies such as setting up a trust.
Social Security will pay a one-time death benefit of $255 to your spouse if he or she has been living in the same house as you. If there is no spouse, the worker’s child or children can receive the benefit. They must apply for this payment within two years of your death. Other rules may affect their eligibility.
Then, there are survivor benefits. People think of Social Security as a pension during retirement, but some of the money you pay into the system could later serve, in effect, as a life insurance policy for your heirs. The same credits that entitle you to your own benefits also entitle certain people to survivor benefits – your spouse, a divorced spouse, children or dependent parents. Spouses can receive full survivor benefits once they reach their full retirement age, between 66 and 67, depending on their birth year. They may be able to receive some payouts earlier if certain conditions apply.
According to the Social Security Administration, 98 out of every 100 children could get benefits if a working parent dies. Your unmarried offspring can receive benefits up to age 18 or 19 if they’re still attending elementary or secondary school full time. If they were disabled before the age of 22 and remain disabled, they can receive benefits at any time. Stepchildren, grandchildren, step-grandchildren or adopted children can receive benefits under certain circumstances.
Divorced spouses can receive benefits if the marriage lasted at least 10 years, or if they’re caring for your child who is under the age of 16 or disabled. The child must be your former spouse’s natural or legally adopted child.
Like your own payouts, the size of survivor benefits depends on your average lifetime earnings. Naturally, the more money you made, the larger the payments to your spouse. In general, a person can only receive one benefit at a time. Widows and widowers have the option of collecting their survivor benefits first, then switching to their own benefit at a later date if that is higher. (For example, your surviving spouse could wait until 70 to switch to her/her individual benefit if that is higher than the survivor payment.) When a surviving spouse retires, Social Security will always pay an individual's personal benefits first. If his or her survival benefits are higher than the personal benefits, that person gets a combination of benefits, in a sum equal to that of those larger survival benefits. "For example, if your spouse’s benefit was $1,200 per month and you had your own benefit of $600 per month, then your total Social Security benefit going forward is $1,200," says Mark Hebner, founder and president of Index Fund Advisors, Inc.
, in Irvine, Calif., and author of "Index Funds: The 12-Step Recovery Program for Active Investors."
The rules for survivor benefits are very complicated. They’re so complicated that Social Security requires that you speak to a representative to receive them. (For a quick rundown on benefits, see When Do Social Security Benefits Start and End?)
The Bottom Line
Nobody likes to think about his or her death. But for the sake of your loved ones, take time now to arrange your accounts, making sure the proper plans and beneficiary designations are in place. If you're married, talk to your spouse about organizing her or her funds so that you are mutually protected. You worked hard for the money – now make it easy for your survivors to access it.