Who gets what?

One advantage a 401(k) plan or an Individual Retirement Account has over a fixed-benefit pension is that it doesn’t expire along with its owner. The more money you earn, the more important that fact is. While the average American’s retirement plan is valued at $334,000, according to the Federal Reserve, the average retirement plan for the top 10% — and that group likely includes you – is more than $913,000.

So, if you manage your money well and live only off that account’s interest, someone is likely to get close to a million dollars upon your passing. And bear in mind, that’s a mean average, not a ceiling, so you might have considerably more to leave to your heirs – especially if you have more than one retirement account. Another reason the Fed is probably undercounting your particular circumstance: This figure averages in people who are still in their 30s and, if you’re reading this, that stage of your life is probably well over your shoulder by now.

Let’s talk, then, about how you make sure the right person or persons get it. That way, maybe you can get through the Christmas season without too much drama.

Rules of the road

We start by identifying the choices that are taken out of your hands. A lot of rules were put in place in 2019 as a result of the SECURE Act, which was passed to incentivize retirement planning and increase access to a wider array of tax-advantaged savings programs.

To start with, your spouse gets dibs on your 401(k) or a specially designated “spousal” IRA. Under federal law and many state laws, qualified defined-contribution plans are inherited by the surviving spouse automatically. Also, because two spouses are usually, for both income and estate tax purposes, one entity, it’s almost as if there’s been no change in ownership. This gives the surviving spouse a lot of leeway when it comes to tax planning.

The only downside is that the surviving spouse usually must abide by the required minimum distribution requirements and start withdrawing no later than age 73. If your spouse is at least 10 years younger than you, though, that defers the dates that you have to stop making contributions and have to start taking distributions. As a result, there’s likely going to be more funds in the account upon your passing.

But what if you aren’t married at the time of your death? You’re then free to leave your retirement money to anyone you like: children, siblings, friends, charities. Minor children can’t inherit your 401(k) or IRA directly; you’d need to set up a trust.

Selecting beneficiaries for retirement accounts is not the same as selecting beneficiaries for life insurance, though. Nor is it like passing along such assets as brokerage accounts or real estate, which generally don’t constitute a taxable event. When you pass along your 401(k) or IRA, though, you need to consider the tax implications – estate tax, yes, but primarily income tax. Otherwise, your chosen beneficiary could actually have a disincentive to accepting your inheritance and might be well-advised to decline it.

It matters if you’re bequeathing a pretax or a post-tax benefit. When someone inherits a traditional IRA and 401(k), they have to pay income tax whenever they withdraw money. But you’ve already paid the income tax on any Roth account, so your heirs would be off the hook. That’s as if we needed another reason to suggest you consider Roths.

You should also advise your heirs about required minimum distributions, or RMDs. Morningstar has a more thorough breakdown of these rules for inheriting 401(k)s or IRAs:

• RMDs don’t apply to spouses or to chronically ill beneficiaries; they can take distributions over the entire course of their lifetimes.
• Most other beneficiaries must withdraw all funds within 10 years.
• Minor children – in this case, those under 21 – must withdraw funds within 10 years of attaining majority.
• Charities must withdraw all funds within five years.

How to … and how not to

When you open an IRA or enroll in a defined-contribution plan, you’ll be offered a beneficiary designation form. At the risk of repeating ourselves, you should fill it out if at all possible. Otherwise, the whole business goes to probate and the court decides who gets what. By the way, if you named one person as the beneficiary on the designation form but named someone else as the inheritor in the will, according to the American College of Trust and Estate Counsel, the designation form takes precedence. And, just like you should take a fresh look at your will every few years, you should do the same with your beneficiary selections.

One reason for that is, to be frank, our beneficiaries occasionally predecease us. When that happens, your estate would probably be named the beneficiary and, again, your heirs will be stuck dealing with probate.

You can mitigate this risk if you’re single by naming multiple inheritors. If you name them as primary beneficiaries, then they all get a share – and not necessarily an equal one. The common practice is to leave different accounts or sub-accounts to different survivors.

But you can also name secondary or “contingent” beneficiaries. If a primary has already passed away or declines due to tax or other considerations – they have nine months to make that decision – that’s when the secondary can make a claim.

Incidentally, the estate tax – it’s also known by the morbid nickname “death tax” – doesn’t apply to too many people. If you and your spouse leave a legacy of less than $13.6 million – 2024’s threshold which goes up every year – it doesn’t affect you at all. If your estate does end up having to file a Form 706 estate tax return – what a problem to have! – there is an array of deductions and credits that could significantly reduce its burden. That said, your estate would have to pay a 40% incremental rate for assets you couldn’t shield. One of those deductions is for inheritance taxes that are charged by the states. The good news there is that two-thirds of the states have no inheritance tax at all, according to Kiplinger. (The other third isn’t necessarily the ones you’d guess.)

Dying is hard

If you’re married at the time of your passing, then, the rules for inheriting your 401(k) can be very simple: Your spouse gets your 401(k) as a tax-free event. (With IRAs, it’s a state-by-state question.) If you’re single, though, it gets very complicated very fast. Ultimately, you won’t need any more advice on where you’re going, but your survivors probably will. Maybe now is a good time to introduce them to your advisor.