When you set up your 401(k) plan, you are asked to choose your before-tax or after-tax deductions, investment choices, and plan beneficiaries. These are any individuals or entities whom you want to designate to receive assets from your retirement plan in the event of your death.
Most people only worry about adjusting the first two options for a high savings rate with pay raises or better investment choices based on performance or risk tolerance while neglecting beneficiary designation.
While your beneficiary designations need not be reviewed every year, they should be reviewed as often as you review or update your last will and testament—which is a process that should be done at least every few years. At a minimum, review and update beneficiaries following life-changing events, such as a marriage, divorce, birth, or death.
401(k) Beneficiary Designations Avoid Probate
Unlike other property and assets, funds held in a 401(k) or another employer-sponsored retirement plan with a beneficiary designation are treated similarly to transfer-upon-death (TOD) assets, such as securities held in non-retirement accounts that allow for TOD registration. Under 401(k) beneficiary designation rules, that ownership of the 401(k) assets is transferred to the designated beneficiaries upon your death rather than being divided as stated in your will or determined by a probate court if you don't have a will.
This means that 401(k) plan assets are generally allowed to pass to the surviving beneficiary outside the probate estate, enabling the designated beneficiaries to avoid the time and expense of the probate process. The downside is that if the deceased's wishes for those assets have changed, but the beneficiaries have not been updated accordingly, there is little that survivors can do. Additionally, if all of the designated beneficiaries predecease the account owner but the beneficiaries were never updated, then those assets will be subject to the time and expense of probate.
Not designating beneficiaries for your 401(k) plan can subject survivors to the costly and time-consuming probate process.
Designating 401(k) Plan Beneficiaries
To take advantage of the pros of account beneficiaries while avoiding the cons, the first step is to designate primary and contingent beneficiaries for your 401(k) plan.
When you first set up your 401(k) or IRA, you will be given the opportunity to designate beneficiaries online or on a beneficiary form provided by the plan provider. On this form, you must indicate a primary beneficiary and a contingent, or secondary, beneficiary for your 401(k) plan.
A primary beneficiary is the first to receive your account balance in the unfortunate circumstance that you die. A contingent beneficiary or beneficiaries, in contrast, is designated in the event that the primary beneficiary of your 401(k) predeceases you. Since a deceased person can't inherit assets, your 401(k) account balance would go to the contingent beneficiary you identified only if your primary beneficiary is no longer alive.
When deciding who to name as a 401(k) primary or contingent beneficiary, keep in mind that under the beneficiary rules for most defined-contribution plans such as 401(k) plans, your surviving spouse will be the first to receive your retirement benefits by default. The beneficiary designation rules of the plan may require you to get his or her formal consent through a waiver if you want to choose a different beneficiary. However, if you're single, you're generally free to name any beneficiary.
Generally, the summary plan description provided by the administrator of the retirement plan will establish the amount and form of the death benefit, along with whether rollovers of the benefits into other accounts are permitted and how they are handled. But the beneficiary designation form will also give you the option to designate the percentage of account assets to go to the beneficiaries.
Let's say, for example, that you are married and have two children. You may choose to make your spouse your primary beneficiary at 100%, meaning that if you pass, your spouse will inherit the entire account value. In case your spouse predeceases you, you can also elect what is known as the "per stirpes" option, which would allow you to allocate his or her 100% benefit to your children in equal portions. Should your spouse pass before or at the same time as you do, each of your two children would receive 50% of the account value.
The per stirpes designation allows you to, in effect, roll over assets that would have gone to your beneficiary to that beneficiary's descendants if you were to outlive him or her. If you don't choose the option, whatever percentage you assigned a beneficiary whom you outlive would get divided equally between other primary or contingent beneficiaries.
Importance of Updating Beneficiary Designations
While treating your beneficiary designation form as a one-and-done exercise can often be okay, it can occasionally be extraordinarily problematic.
Let's say that you initially named a spouse as a primary beneficiary and subsequently get divorced. Years later, you remarry. You update your will so that your new spouse will inherit your home and other assets upon your death. Being thorough, you also contact your life insurance agent and similarly provide the necessary updates. But you don't change your retirement account beneficiaries.
Years later, you die. Your home will pass to your new spouse, following the terms of your will. Life insurance proceeds will also go to your new spouse, thanks to that call you made to your life insurance agent. The 401(k) beneficiary designation form is the guiding document, which is a disadvantage in this case. Your 401(k) plan may go to your former spouse because you never updated the 401(k) beneficiary designation form.
In order to avoid similar scenarios, make sure that you periodically review those 401(k) beneficiary designation forms, especially if you've had any major family changes since you set up the plan. You and your loved ones will be grateful that you did.
Final Thoughts On 401(k) Beneficiary Designations
Most people hesitate to consider the eventuality of their death, particularly when enrolling in a 401(k) plan for an exciting new job and making decisions about contributions and investments.
But because the transfer of your 401(k) account assets does not follow the terms of a will like your other assets, neglecting to name beneficiaries may unwittingly subject your loved ones to the emotional toll of the probate process—not to mention the financial toll of not receiving assets in a timely fashion—in the event of your passing. Planning for the worst now by naming beneficiaries for your 401(k) plan assets can ensure a smooth transition of assets to the people who need them in your absence.