Thinking about retirement? Like most people, you’re probably most worried about having enough money to live comfortably. But what people often forget to plan for—quite understandably—is what happens after they die. For the sake of your spouse or other family members, make sure things are set up correctly. It’s not enough to just make the money—you have to protect it and ensure it gets into the right hands after your death.

Retirement accounts with ill-conceived beneficiary designations could potentially cost your family tens of thousands or even hundreds of thousands of dollars if done wrong. Correct beneficiary designations are crucial for retirement plans, and there are a lot of pitfalls and mines to avoid when naming both the primary(s) and contingent beneficiary(s). To avoid penalties and taxes, you really need to seek counsel from a competent advisor fluent in estate planning.

Key Points

  • People should ensure certain measures are in place to guarantee that their money goes where they want it to in the event of their death.
  • IRAs, 401(k)s, and estate taxes are all handled differently if your spouse passes away.
  • Social Security survivor benefits may vary significantly depending on the beneficiaries and marital situation.

Individual Retirement Accounts (IRAs)

Individual retirement accounts (IRAs) are generally not covered in your will. So when you open an IRA, you should complete a beneficiary designation form. This form names the person or people who will receive your IRA and in what proportions. You can amend the form at any time, but whoever is on the form upon your death will receive the funds—even if they are an ex-spouse or a disinherited child.

Five Options of the IRA Beneficiary.

1. Keep the Inherited IRA

This is a good option if the deceased already started taking required minimum distributions from the account. As a bequest, it allows your beneficiary to withdraw those funds too, even if they are younger than age 59½, without having to pay the usual 10% early withdrawal penalty.

If the heir is a surviving spouse, a minor child, or a disabled person, the RMDs continue to be based on the deceased person’s age rather than the beneficiary’s—that is, unless the beneficiary submits a new schedule based on their age. If the heir is not a spouse, they must withdraw all the funds within 10 years of the original owner’s death. These withdrawals may be subject to income taxes.

If you inherit a Roth, you have to take RMDs even though the deceased wasn’t required to take them as the rules are different for beneficiaries than for participants. The one benefit here is that you won’t owe tax on the money.

2. Roll Over the IRA

Another option is to take the assets and roll them into a personal IRA—either a new one or a pre-existing one—without paying income tax or early-withdrawal penalties, unless you are under age 59½ when you subsequently take a distribution.

If you roll over an inherited Roth IRA, you do not pay penalties if the assets have been in the account for five years. This rollover option is only open to a surviving spouse who must transfer to the same account type—traditional IRA to a traditional IRA or Roth IRA to a Roth IRA.

If the spouse rolls it into their personal IRA, they can update the beneficiaries and put off taking RMDs if they are less than 72 years old.

3. Convert to a Roth IRA

If you anticipate being in a higher tax bracket later in life, it might be advantageous to convert a traditional IRA into a new Roth IRA account. Be aware that you will pay all applicable income taxes at this time, but down the road, you won’t owe any more taxes or have to take RMDs.

4. Disclaim All or Part of the Assets

Sounds confusing, right? Basically, this means you give up any and all claim to the funds, which then go to the other beneficiaries mentioned in the designation form.

5. Take the Money

You do have the option to cash out the IRA. You will pay all applicable taxes at that time, and it may push you into a higher tax bracket. If the IRA is sizable, speak to a financial advisor about tax-efficient ways to cash out.

401(k) Plan

Things are slightly different with a 401(k). You will still complete a form that designates who receives your benefits when you pass away. If you’re married, though, the law says your spouse becomes the recipient. Even if you’ve been legally separated for years and now live with somebody else, your spouse is entitled to the account upon your death. The only way that can change is if your spouse signs a document giving up their rights as a beneficiary.

Divorce settlements generally include provisions for whether ex-spouses are entitled to any 401(k) money, in keeping with the rules of each spouse’s plan.

“Always update your employer 401(k) beneficiary designation paperwork immediately after a divorce to reflect the intended beneficiary and consult an estate planning attorney to ensure your intended wishes will be carried out at your death—especially if you have remarried—to avoid future conflict. Otherwise, your ex-spouse may get something that was not agreed upon.

If you’re single, the people on your beneficiary form receive the account.

The recipient’s options with a 401(k) are basically the same as with an IRA—keep it, roll it over somehow, cash it out (a non-spousal beneficiary must do this within a decade), or decline to receive it.

Estate Taxes

Any time the topic of assets and death arises, it’s natural that estate taxes also come up. If you pass away in 2021, your beneficiaries wouldn’t be affected by federal taxes if the total value of your estate is $11.7 million or less.

If it exceeds that amount, talk to an estate lawyer or tax attorney as soon as possible to discuss strategies for legally sheltering assets. It may involve strategies such as setting up a trust.

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