Every time you establish an Individual Retirement Account or a 401(k) plan you must choose who will receive distributions from the funds after your death. The choice of these beneficiaries will affect the tax status of the distributions and thus the amounts they will receive.
Bear in mind the law makes important distinctions between the two types of plans: traditional IRAs and 401(k)s and Roth IRAs and Roth 401(k)s. Beneficiaries will pay the applicable income tax rate on the first type but not the second.
Under all plans, you must name a primary beneficiary or beneficiaries - the person(s) who has the first right to the distribution, such as surviving children or your spouse. You must also designate a secondary beneficiary or beneficiaries, who will receive the distribution if the primary one(s) is not alive - you can choose more than one primary beneficiary as long you specify the percentage each person gets. The percentages do not have to be equal, and you can adjust them for the death of one or more beneficiaries. These designations can be changed at any time to accommodate family changes or different financial circumstances.
If no beneficiary is alive or is stated at the time of your death, the situation becomes more complicated. The funds will pass to your estate, which may end up being administered by the court at considerable cost to heirs. In addition, these probated distributions will have to be expended quickly, placing a higher tax burden on the estate. Having an airtight set of beneficiaries gives you maximum control over who receives your retirement distributions.
The best course is to name your spouse as the primary beneficiary. They can take the most tax-saving distributions and roll over IRA and 401(k) distributions into their own retirement accounts. Surviving spouses can also treat IRA accounts as their own, possibly conferring other benefits. However, it is possible these combined funds will make the spouse’s estate large enough for so-called death taxes.
As always, it’s advisable to consult a tax accountant or financial planner to find the best way to allocate your IRA and 401(k) distributions.
