Subject to your spouse’s legal rights, you can name whomever you want to inherit your qualified plan or IRA account.
Nonspouse beneficiaries (as the IRS calls them) who inherit an IRA or 401(k) account don’t have all the options that a surviving spouse does—they cannot roll the account over into their own accounts. But they can probably manage to keep the money in the account growing tax-deferred, if that’s their goal. Here’s how it works.
Someone who inherits an IRA from someone other than his or her spouse has three choices.
It’s always possible for the beneficiary to simply withdraw the money from the account. This might make sense if the beneficiary really needs the money for buying a house, paying for college, or starting a business. Even a beneficiary who is not yet age 59 ½ can take out money without paying the usual 10% early withdrawal penalty. The beneficiary will, however, have to pay income tax on the amount withdrawn.
If the plan allows it, the beneficiary will be able to leave the IRA in the deceased person’s name and make required minimum withdrawals over his or her own life expectancy, as determined by IRS tables. Some plans, however, require the beneficiary to withdraw the entire amount within five years. In that case, it’s probably better to create an inherited IRA, as discussed next.
A non-spouse beneficiary can create an “inherited IRA” for the money in an IRA or qualified plan. The beneficiary can’t contribute to the account, which stays in the name of the deceased person, but the inherited funds can continue to grow tax-deferred.
There are important rules to follow to roll an inherited 401(k) plan into an IRA, and a beneficiary who doesn’t follow them will end up paying tax after all. The trustee of the account plan must transfer the money directly to the new IRA; this is called a “trustee-to-trustee transfer.” If the beneficiary takes a check for the money, and then turns around and puts it into an IRA, income tax will be due on the whole amount.
Every beneficiary must take required minimum distributions (RMDs) from the retirement account and pay income tax on these distributions. The amounts depend on whether or not you, the original account holder, had already begun taking required minimum distributions.
If RMDs had not yet begun, then the beneficiary’s RMD is based solely on his or her statistical life expectancy. This rule also applies to an inherited Roth IRA.
If RMDs had begun (at age 70 ½), then in the year of your death, the amount you would have had to withdraw must be taken out. After that, RMD amounts are based on the beneficiary’s statistical life expectancy—which lets a young beneficiary stretch out the payments for many years. (These IRAs are often called “stretch IRAs” for that reason.)
You can name a minor—that is, a child younger than 18 years old—as the beneficiary of your retirement account. In fact, children are common beneficiaries; single parents may name their children, and grandparents may wish to leave some money directly to grandchildren. And even if you don’t name a child as your primary beneficiary, you may want to name one as an alternate.
If you name a minor, however, take another step: Arrange for an adult to manage the money in the event that the beneficiary inherits this money while still under 18. Choose an adult and give that person authority to manage the money without court supervision. The easiest way to do this is to name an adult to serve as "custodian" of the money. Custodians are authorized under a law called the Uniform Transfers to Minors Act (UTMA), which has been adopted by all but two states.
If you don’t, and a child inherits more than a few thousand dollars, the child’s parents will probably have to go to court and ask to be appointed guardians of the money. If neither parent is alive, the child’s court-appointed and court-supervised guardian will handle the money.
It’s generally not a good idea to name more than one beneficiary, for two reasons.
First, if you name your spouse and someone else as cobeneficiaries, your spouse loses the special flexibility he or 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.
One option, if you want to divide your retirement plan assets among several people, is to split the account now into several, and name a beneficiary for each.
You can name your own estate as the beneficiary of a retirement plan—but doing so ensures that the money in the account will have to go through probate before being distributed. And if you die before age 70½, all the money will have to be withdrawn in five years. If you die after age 70½, whoever inherits the account will have to continue making withdrawals as fast as you would have. So the smart course is simple: Don’t do it.
If you’ve set up a living trust to avoid probate, good for you—but your trust should probably not have anything to do with your retirement accounts.
First of all, you don’t need a living trust to avoid probate for the money in a retirement account. If you name a beneficiary (other than your estate), the money won’t go through probate.
A potential drawback to naming a trust is that the trust beneficiary won’t be able to name new beneficiaries. For example, if you create a trust for your spouse and name the trust as the beneficiary of your retirement plan money, your spouse will be provided for. But she won’t be able to roll over the account into her own retirement account and name her own beneficiaries, perhaps your children. Those children in turn could have kept the money tax-deferred, taking out only small minimum required distributions based on their long life expectancies.
If you do name a revocable living trust as the beneficiary of your retirement account, required minimum distributions after your death will be based on the life expectancy of the oldest trust beneficiary (if the beneficiary is a person, not an institution). And an older beneficiary means a shorter life expectancy and larger minimum payouts—shortening the time the money stays in the tax-deferred account. If there is more than one beneficiary, they must all receive equal distributions.
You can name a charity or institution as the beneficiary of your retirement account. While you’re alive, minimum required distributions are based on the IRS Uniform table, which assumes that you have a beneficiary ten years younger than you are.
After your death, the charity must take out the money within five years (if you die before age 70½) or take distributions based on your life expectancy (if you die after age 70½). Minimum distributions usually aren’t a problem for charities, which are happy to cash out the accounts they inherit. But if you name a person and a charity as co-beneficiaries, after your death the IRS treats the situation as if you had not named a beneficiary at all, meaning distributions will be accelerated for the individual beneficiary as well as the charity.