Naming a Non-Spouse Beneficiary for Retirement Accounts

Here are some considerations when naming someone besides a spouse as a beneficiary to your qualified plan or IRA.

Subject to your spouse's legal rights, you can name whomever you want to inherit your qualified plan or IRA account. But it's useful to know that non-spouse beneficiaries (as the IRS calls them) who inherit an IRA or 401(k) account don't have as many options as a surviving spouse does—they cannot roll the account over into their own accounts, for example, and they usually must withdraw the entire account within 10 years of the account owner's death. (See How the SECURE Act Affects Your Retirement and Estate Plans for more on this 10-year deadline.)

The Non-Spouse Beneficiary's Options

A beneficiary who inherits an IRA from someone other than his or her spouse has three choices.

Take Out the Money

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 The beneficiary will, however, have to pay income tax on the amount withdrawn, and a large sum taken out at once might bump the beneficiary into a higher tax bracket.

Create an Inherited IRA

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. However, most non-spouse beneficiaries will need to withdraw the entire amount in the account within 10 years after the original account owner's death. There are only a few exceptions:

  • Minor children can take required minimum distributions (RMDs) based on their expected lifetimes until they reach adulthood—usually 18 years of age. The RMD amount will be relatively small, since minor children have long life expectancies. However, upon reaching adulthood, the child will then have 10 years to deplete the account.
  • Disabled or chronically ill individuals (categories defined by the IRS) can also take RMDs based on their statistical life expectancy, and the 10-year rule will not apply.
  • Individuals not more than 10 years younger than the original account holder (such as a sibling who is five years younger) will also be exempt from the 10-year rule and can take RMDs based on their own life expectancy.

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 might be due on the whole amount.

Disclaim (Decline to Inherit) the Account

If a beneficiary declines to inherit all or part of the assets in the retirement account, the assets will pass to other eligible beneficiaries. For example, if you named your daughter as the primary beneficiary of your retirement account, and your grandchild (your daughter's son) as the alternate beneficiary, your daughter has the ability to disclaim the account so that it goes to her child. She might have various reasons for choosing to do this—perhaps she doesn't need the money, or perhaps she is in a much higher tax bracket than her child.

Special Issues When You Name a Minor Beneficiary

You can name a minor—in most states, that means 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 before reaching the age of majority. 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 states except South Carolina.

If you don't name a custodian, 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.

Naming More Than One Beneficiary

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 some but not all beneficiaries are exempt from the 10-year rule and are allowed to use their own life expectancies to determine the amount of RMD. 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.

Naming Your Estate

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 probate proceedings can cost additional time and money on the part of your beneficiaries.

Naming a Trust

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 anyway.

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.

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