Tax Article - Choosing Your Retirement Plan Beneficiaries

3 key questions to ask

Target Audience: Retirement Aged Workers, Estate Planners, Charitable Donations

When you think of retirement planning, you probably think of yourself. How much money will you need to live out your retirement dreams?

But another important aspect of retirement planning is having a strategy for giving away your nest egg should you not be around to enjoy it. More simply put, you need to choose your retirement plan beneficiaries. Here are three key questions to ask when making this important choice.

1. What About Income Taxes?

Unlike most inherited assets, such as stocks and real estate, funds that beneficiaries receive from traditional 401(k) plans, traditional IRAs and most other retirement plans are 100% taxable unless you used nondeductible contributions to fund the account.

The important elements to consider are how long the beneficiary will be able to defer distributions, how large any required minimum distributions (RMDs) will be, and his or her tax bracket.

Annual RMDs usually are required to begin shortly after the plan owner’s death. An employer-sponsored plan, however, may require the beneficiary to take a lump sum distribution of the plan’s balance, though recent tax law changes let most beneficiaries rolled the funds into an IRA, which will be treated as an inherited IRA.

Just how big will those RMDs be? That depends on the account’s size and the beneficiary’s age. Younger beneficiaries will face smaller RMDs, which brings greater opportunity for tax-deferred growth as the account is drawn down at a slower rate. And a younger beneficiary is more likely to be in a lower tax bracket, at least for the early years of RMDs.

Children aside, many people prefer to name a spouse as beneficiary — and for good reason. Because spouses can treat inherited IRAs as their own, they can delay distributions until turning 70½.

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2. How Will Your Estate Be Taxed?

Another reason many people opt to name their spouses as beneficiaries is the estate tax ramifications. Naming anyone else can increase taxes on your estate. A number of factors — such as the dollar value of the account’s assets and size of your estate — will determine whether it will result in any estate tax liability.

Because transfers to your spouse (provided he or she is a U.S. citizen) are deducted in arriving at the taxable estate, naming your spouse as beneficiary will allow you to steer clear of estate taxes on the plan’s assets when you die. This, in effect, makes the assets “neutral” when considering the impact on your estate taxes.

One caveat, however: The assets will boost the size of your spouse’s estate. And that could raise estate taxes on his or her assets when he or she dies.

3. Should You Consider Nonfamily Beneficiaries?

Although naming a spouse or child is often advantageous, it’s not your only option. A trust or charity may better fit your wishes.

Take a trust, for example. Naming a trust as beneficiary can allow a married person with a taxable estate over the $3.5 million exemption limit to give as much as possible to heirs while still permitting a spouse to have access to the funds if needed. Single parents may also look to a trust to protect retirement plan assets for the benefit of children or other young beneficiaries.

There are, however, specific tax rules governing trusts as plan beneficiaries that must be adhered to in order to ensure that RMDs are based on the ages of beneficiaries who receive them. Otherwise, the RMDs will be determined as though your estate were the named beneficiary.

A charity is another choice. In this case, neither your estate nor the charity will owe income tax on the retirement plan assets. Moreover, your estate may qualify for a charitable deduction for estate tax purposes.

Naming both a charity and individuals as beneficiaries, however, could limit the tax-deferral opportunities of the noncharitable beneficiaries. You can avoid this problem by splitting your accounts so that the charitable beneficiaries and the noncharitable beneficiaries don’t have competing interests in the same account.

Knowledge Is Power

For many people, the choice of a retirement plan beneficiary is relatively simple: a spouse or child. Nonetheless, it’s important to know all of your options and how each will affect you and your beneficiaries.

Don’t Bail On Your Retirement Plan In Rough Waters

Bailouts. Unemployment. Bankruptcies. The uncertainties of the economy have been in the news for months. But what does all this mean for your retirement plan? Should you bail on your 401(k) because the economy has hit rough waters?

1. If you did, you wouldn’t be alone. A survey of 1,005 individuals conducted last fall by Opinion Research Corp. found that 63% of respondents had stopped contributing to their retirement plans while 35% had reduced their contributions.
   
2. Good move? Not likely. Remember, the stock market is cyclical by nature. So as far as your account balance may have dropped, there’s a strong chance that it will rebound eventually. Here are some other smart ways to keep your nest egg afloat:
3. If your employer offers a match, make full use of it if you aren’t already.
   Revisit your portfolio’s balance — maybe now is the time to make adjustments.
   Cut back on spending and refocus on saving in the here and now as well as for retirement.
   
4. If you’re nearing retirement, consider part-time post retirement employment.
   

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