When you create an IRA or enroll in a 401(k) plan, the forms you fill out will ask you to name a beneficiary. You will probably also be given the opportunity to name an alternate (sometimes called secondary or contingent) beneficiary, who will inherit the money if your first choice dies before you do.
Most married couples name each other as beneficiaries—a good choice, because a surviving spouse who is the sole beneficiary has more flexibility about what to do with the money than do other beneficiaries. Unlike other beneficiaries, a surviving spouse, in some cases, can keep all the money tax-deferred at least for a while. (This isn't a concern with the Roth IRA, because withdrawals generally aren't taxed.)
If you want to name someone other than your spouse as beneficiary, make sure you don’t run afoul of state and federal laws designed to protect surviving spouses. (See “If You Don’t Want to Leave Retirement Accounts to Your Spouse.”)
A surviving spouse who is the sole beneficiary of a retirement account has two options: rolling over the account or leaving it as it is, as an “inherited IRA.” For the most part, it doesn’t matter whether the account owner died before or after reaching the age at which required minimum withdrawals must begin. There is, however, one significant exception: If the minimum withdrawals have become required, then the surviving spouse must make the withdrawal for the year of death. After that, he or she can exercise one of the following choices.
A spouse can roll over the money in an IRA or qualified plan such as a 401(k) to her own IRA (new or existing). To do that, the spouse needs to contact the retirement account administrator and complete some paperwork.
Once the account has been rolled over, everything is just as if the surviving spouse were the original owner. The surviving spouse can name a beneficiary to inherit the funds at her death. Required minimum distributions will begin when she reaches age 70½, and the amounts will be based on her life expectancy as set out in IRS tables. (If the spouse remarries, required withdrawals will be based on the joint life expectancy of the survivor and the new spouse.)
The surviving spouse doesn’t have to pay income tax on money in the account until it is withdrawn. Meanwhile, the funds can keep earning tax-deferred income.
The survivor can also roll an IRA or 401(k) into his or her own Roth IRA. Taxes will be due on the entire amount that’s rolled over, however, so this would make financial sense only if the survivor expects to pay higher taxes later, when he or she would be withdrawing the funds.
A spouse can also leave the retirement account in the deceased spouse’s name as an “inherited IRA.” The survivor must begin taking required distributions by the later of:
This option might make sense if the survivor is under age 59½ and expects to withdraw money from the account soon. Beneficiaries are not subject to the usual 10% “early distribution” (before age 59½) penalty, but they lose that special exemption if they roll over the account. If circumstances change, the survivor can roll over the account later.
EXAMPLE: Annie is 45, with two children still at home, when her husband dies and she inherits the money in his 401(k) plan account. She may need to withdraw money from the account in the next few years. If she rolled over the money into her own retirement account, and then withdrew some of it before age 59½, she would have to pay a 10% early withdrawal penalty. So instead, she leaves the money in her late husband's account. It will continue to earn income that won't be taxed until she withdraws it, and she can make withdrawals without penalty.
The survivor can name a beneficiary, but the amount of the minimum required distributions is determined by the surviving spouse’s life expectancy, as found in the IRS single life expectancy table. She can't use the Uniform table that assumes a beneficiary who is ten years younger.
It's generally a bad idea to name more than one beneficiary, for two reasons.
First, if you name your spouse and someone else as beneficiaries, your spouse loses the special benefits and flexibility she would otherwise have.
Second, it complicates things. If you die before age 70½, then multiple beneficiaries can split your account, and each can use his or her own life expectancy to determine the minimum amount they must withdraw each year. But if your beneficiaries inherit after you reached age 70½ and had to begin making minimum withdrawals, the total amount that must be withdrawn each year is based on the statistical life expectancy of the oldest beneficiary. If some beneficiaries are much older than others, the younger ones will have to withdraw money (and pay tax on it) much more quickly than they may wish to.
When you name your spouse as primary beneficiary, you’ll probably be able to name an alternate—someone to inherit the money if your spouse doesn't survive you. Alternates are also called contingent or secondary beneficiaries. Many people name their children as the alternates. Be sure to enter an alternate’s name—if you don't, you could cost your offspring money.
EXAMPLE: Frances names (on the form she gets from the account administrator) her husband Sean as the primary beneficiary of her IRA. She doesn't name a secondary beneficiary. Years later, Sean, now in his 80s, dies, and Frances dies soon after—without updating the beneficiary paperwork. Because there is no designated beneficiary, the money passes to her son Colin under her will. He must withdraw it all within five years. Had Colin been named as the alternate beneficiary, he could have withdrawn the money over his own life expectancy—more than 40 years.
Naming an alternate beneficiary also gives your family more flexibility after your death. It's easy for a beneficiary to “disclaim” his or her inheritance—that is, to turn it down in favor of the alternate beneficiary. A surviving spouse who doesn’t need the money could let it go to the children instead, allowing withdrawals to be spread out over a longer period.
EXAMPLE: Harvey names his wife, Marlene, as the primary beneficiary of his IRA and his son, Matthew, as the alternate. When Harvey dies, Marlene is in her 70s and doesn't need the money in the IRA. She disclaims her interest in the money, letting it pass directly to Matthew, so he can stretch distributions over his much longer life expectancy and let the money in the account continue to grow.