Ever thought what would happen to your assets after your death? People avoid thinking of death because such thoughts are dreadful. However, if you want your assets and property to pass on to your wife and children without any hassle, then you need to think about this scenario and update your estate plan.
Insurance companies often ask policyholders whom they want to name as beneficiary/beneficiaries. Many other organizations do the same when people sign up for their schemes. One such scheme is 401(K).
401(K) is employee-sponsored retirement savings plan. At the time of setting it up, you have to name two beneficiaries – one primary and another secondary.
Here are some info about naming 401(K) beneficiary:
401(K) inheritance rules
Because the rules are bit a complicated, one needs to read them very carefully. Who will inherit the money in your 401(K) account depends on whom you name as beneficiary. Your spouse is the default beneficiary unless s/he signs a waiver. You can designate someone else as 401(K) beneficiary – be it children, a friend or an organization only if your spouse waives his/her right.
This rule applies to both traditional and Roth 401(K) plans. Paying tax in time is very important. Otherwise, your heirs will inherit an annoying burden of tax. Regarding this, an estate planning specialist called Rodney Weaver said “After deciding who you want to inherit the money, the main objective is to reduce the tax bill.”
401(K) and tax
The second most important thing after naming beneficiaries is to clear all taxes generating on your 401(K) account.
Remember the tax schemes for traditional and Roth 401(K) require deep understanding. As per the law, federal estate tax will apply to your 401(K) plan if its value outpass the tax exclusion limit and the federal lifetime amount. The exclusion amount for 2016 is $5.45 million for singles and $10.9 million for married couples. The gift tax exclusion amount (yearly) for 2016 is $14000.
Income tax also affect beneficiaries who inherit 401(K). In this regard, there’s a difference between traditional and Roth 401(K). A Roth 401(K) can never be subject to income tax because money is contributed after tax deduction. The following inherited assets are not subject to income tax:
- Personal property
- Non-retirement account
- Real estate
That being said, if the combined value of such assets exceeds the tax exclusion limit, then federal tax will be applied. Complicated, isn’t it?
Put simply, if your 401(K) account doesn’t exceed tax exclusion limit, then you have nothing to worry. Among the benefits of retirement saving plans such as 401(K), one is taxation gets deferred on both contribution as well as earning.
However, tax deference is neither forever, nor unconditional. If you withdraw plan assets from tax-deferred account, then you have to pay income tax because it’d be considered as income. Your beneficiaries will have to do the same if they take distributions from a traditional 401(K) plan.
Now we’ve come to the crux of the whole thing – choosing heir/s. As mentioned earlier, for a married person, his/her spouse is the default beneficiary. But married people still need to fill out the beneficiary form.
What happens when you choose a beneficiary who is not your spouse and your spouse doesn’t sign a waiver. If you and your spouse are separated and you name a domestic partner with whom you’ve been living for last 20 years, your spouse will retain legal claim to your 401(K) assets after your demise.
Your spouse will not have any claim in case you two are divorced.
If you are single
If you die single, your 401(K) account will go to whomever you choose as your beneficiary. Sometimes, however, things get complicated for even single people. If single parents name their children as beneficiaries and marry again afterwards, complications will arise.
After remarrying, the spouse becomes the default beneficiary of your 401(K) account replacing children. This means, the form that you’ve earlier signed will no longer be valid. If you want your children to remain your beneficiaries, then you’d have to fill out a new form.
When beneficiary is minor
What if you are naming a minor as your beneficiary?
Assuming your beneficiary is a minor at the time of your death, court intervention will be necessary. Usually, court appoints a trustee who receives the money and hand it over to the child when he grows up.
Sometimes, parents set up a trust and make it the beneficiary, so that the child doesn’t have to start managing a large sum of money all of a sudden. Many parents opt for this model. The only problem is IRS has stringent requirements for beneficiary trusts. Hence, talk to a tax advisor before making any such move.
Naming 401(K) beneficiary may appear simple, but it’s not. This article clearly shows there are too many nitty-gritty that one needs to abide by.
This is a guest post by Tina Roth
Tina Roth is a full-time finance blogger who loves blogging about everything from personal finance hacks to money management and investing on her personal finance blog. You can reach her at @ProFinanceBlog on twitter.