Building assets for retirement may seem challenging enough, but designating beneficiaries to inherit those assets can bring an entirely new set of considerations into the mix. While it may seem simple to use the first name that comes to mind—a spouse, a child, or a sibling—on the beneficiary designation form, you should know the consequences first.
Here's a guide to what's involved.
- Most retirement plans and life insurance policies let you name a beneficiary on the contract to inherit the asset at your death.
- You can avoid probate of a plan or policy by designating a beneficiary, so the asset won’t be subject to creditor claims against your probate estate.
- The asset will most likely contribute to your estate for estate tax purposes unless you designate your spouse.
- You can–and should–update your beneficiary designations periodically if you have major life changes, such as adding to your family.
Naming Primary and Contingent Beneficiaries
Most retirement plans, annuities, and life insurance policies ask you to designate beneficiaries to let you decide what should become of your assets in the event of your demise.
The primary beneficiary (or beneficiaries) inherit first. If they pass away before or with you, your assets would instead go to any secondary beneficiaries you have designated. These secondary beneficiaries are often referred to as "contingent beneficiaries" on account forms.
To designate beneficiaries, you will need the full legal name of the individual. You will also need to determine what percentage of your assets will go to each beneficiary if you have more than one listed.
Beneficiaries can include spouses, children, and other relatives. Alternatively, they can include friends, trusts, charities, and institutions. Because your pet can't sign legal documents or legally own property, you usually can't name them as a beneficiary. However, you can establish a trust for the pet, with the trust itself being the beneficiary.
Overriding Your Will
Be aware that beneficiary designations generally become active immediately after death and override any information regarding inherited assets provided in your will. That means these assets will not have to go through probate, which is a legal proceeding that can be time-consuming and possibly very expensive.
This immediate nature also means that you need to ensure that your current beneficiary designations reflect your most recent wishes because your will cannot override them. It's a good idea to review your designated beneficiaries every year, for all of your accounts. It's also important to update your beneficiary information after any major life change such as marriage, divorce, or the birth of a child.
Taxes on Inherited Retirement Accounts
Spouses can generally inherit assets from one another without generating estate taxes. In the case of retirement accounts, they avoid being forced into taking mandatory taxable payouts. However, if the inheriting spouse has reached age 72 after January 1, 2020, the normal required minimum distribution rules apply to retirement accounts.
Prior to this date, the age was 70 1/2 and was revised as a result of the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in December 2019.
It is best to check with your tax advisor for details, as the mandatory distribution rules are complex.
Heirs other than spouses, though, may face some tax consequences. Loading too many assets on to some heirs may make those heirs' estates liable to pay federal estate tax upon their death. As of 2021, these taxes can be assessed on estates that exceed $11.7 million for an individual. Some states assess state tax on an inheritance above a specific value. Keeping your potential heirs informed of your intentions allows them to plan accordingly.
Requirements to Cash Out the Retirement Fund
With the passage of the SECURES Act, the rules governing required distributions from an inherited retirement account have become very murky. Generally, the options available will depend on whether you are a surviving spouse or a non-spouse beneficiary.
If you are a surviving spouse you can either transfer the assets into an inherited IRA or your own IRA. Which option you choose depends on whether you need to begin withdrawing money immediately and whether you are older or younger than age 59 1/2. If you're younger than 59 1/2 and need the money now, the inherited IRA may be best, as you'll avoid having to pay a 10% early withdrawal fee on the distribution.
If you're over 59 1/2, placing the money in your own IRA might be best. Another factor that comes into play is the age of your spouse at the time of his or her death. Your age and whether your spouse was older or younger than 72 might affect which option is best.
The rules governing non-spouse beneficiaries were made quite simple as a result of the passage of the SECURES Act. Essentially, you must transfer the assets into an inherited IRA and withdraw all assets within 10 years of the original account holder's death. There are certain IRS exceptions to this rule, based on whether there are multiple non-spouse beneficiaries. Other exceptions can be made if the person is a minor, disabled, or chronically ill.
Creating a Trust for Minors or Other Heirs
Underage children, a group that may include anyone up to age 21 in some states, cannot directly inherit assets from an annuity, a retirement plan, or a life insurance policy. Examples of two types of trusts created for minors or others include a testamentary trust and a revocable living trust. Consult with an attorney, if necessary, to set up trusts for minor children. The trust you create then can be named in your beneficiary list.
You may also want to create trusts for beneficiaries with mental disabilities if they are unable to handle their own affairs. This type of trust is often referred to as a "special-needs trust." Specifically for individuals with special needs receiving assets, a third-party funded trust is the vehicle used to protect eligibility for government benefits. There are other special-needs trusts that are considered available assets but receive Medicaid rates for related services. These trusts would include self-funded trusts and pooled trusts.
In summary, there are many important considerations to make when choosing beneficiaries for a retirement account, annuity, or life insurance policy. Make sure you take the time to review your selections carefully to make sure your wishes are up to date and to help your loved ones avoid future headaches.