My old college roommate lost his younger brother to cancer and left my roommate as the beneficiary on his retirement account.
When I heard the news, I was in disbelief. There's no way that someone so young could pass away, could they?
I had heard that my former college roommate's younger brother was sick, but just assumed that he would get better.
When I heard that he had passed away at the age of 34, I was in complete shock. Even to this day, I can hardly believe that he's gone. He was young, athletic, and his heart was bigger than his smile. It just didn't seem right.
A few months had passed, and my buddy reached out to me to inform me that his brother had named him the beneficiary of his retirement account, his 401(k). He wasn't sure what to do, so was seeking my advice.
It's common that we help people take care of the passing of IRAs and other investment accounts to the rightful beneficiary. It was different in this sense since the beneficiary was his younger brother. It's one of those articles that pains me to write it, but I know others will be going through this experience.
Here's what you need to know if this happens to you.
Non-Spouse IRA Beneficiary Rules
The situation that my friend has experienced with inheriting his brother's 401(k) plan is referred as a “non-spouse beneficiary”. This is a term that the IRS uses to describe a retirement plan, such as an IRA or a 401(k) that is ultimately inherited by someone other than the decedent's spouse. It's a special classification because a non-spouse does not have all of the inheritance options that a spouse does. For this reason, there are special rules that apply to non-spouse beneficiaries.
First, there are no rules that require that a retirement plan must pass to a spouse upon the death of the owner. And certainly in cases where the decedent is not married, a retirement plan will necessarily pass to a non-spouse. In fact, it's probably a more common outcome than is generally assumed.
When retirement money is inherited by a spouse, he or she can generally roll the account over into their own retirement plan, and there are no immediate tax consequences.
But a non-spouse is basically limited to three options:
- Take an immediate distribution – You will have to pay ordinary income tax on such a distribution, but there will be no 10% penalty for early withdrawal if you are under 59 1/2.
- Retain the decedent's retirement account – You do have this option, but it will require that you make required minimum withdrawals over your life expectancy. We'll get into this topic in the next section.
- Create an inherited IRA – This type of account will remain in the name of the decedent, and the funds can continue to grow on a tax-deferred basis. You can use this account for either an IRA or 401(k) plan. Though you will be creating a brand-new retirement account, you will not be able to make contributions into that plan.
If you set up an inherited IRA, the money must move directly and immediately from the existing account, into what is known as a trustee- to-trustee transfer. That means that you won’t be able to take receipt personally of distributions or rollover balances from the decedent's retirement plans, and then roll them into another IRA as you can with your own retirement accounts. The money must always move directly from the decedent's account into the new account.
Each Option Must Include Required Minimum Distributions (RMDs)
Whatever option you choose as a non-spouse beneficiary, you will be have to take required minimum distributions (RMDs) from the plan. Exactly how this will be set up, and how much you must withdraw, will depend upon whether or not the decedent had already begun taking RMDs when he or she was alive.
At a minimum, you will have to begin taking distributions that are based on your life expectancy. The IRS actually provides life expectancy tables but it's a fairly complex process, and it will almost certainly require professional help in order to establish one.
If the decedent had already begun taking RMDs, which everyone is required to begin taking at age 70 1/2 with all retirement plans except Roth IRAs***, then the amount of your RMD will be the amount of the decedent's RMD in the year of his or her death.
***(Please note: This discussion of non-spouse beneficiary rules applies to inheriting traditional IRAs and employer sponsored plans, like 401(k)'s only. Roth IRAs have different rules, and much different tax consequences. As such, I may cover non-spouse beneficiary rules in regard to Roth IRAs in a separate article.)
After the year of the decedent's death, or if the decedent had never begun taking RMDs, the RMDs will be based on your own life expectancy.
The RMD rule applies to both inherited 401(k) plans or a traditional IRAs.
You will have to pay ordinary income tax on the RMDs, but there will be no 10% early withdrawal penalty, even if you are not 59 1/2 or older.
The Beneficiary is a Minor – Are the Rules the Same?
This is another common outcome of inherited retirement plans, since children – including minor children – are frequently named beneficiaries on all types of retirement plans. This can sometimes happen even when the decedent is married, but is extremely common in divorce situations.
It is perfectly legal to name a minor as a beneficiary on a retirement plan. But since the minor is a child, he or she will lack the legal capacity to manage the account. For this reason, if you choose to name a minor child as a beneficiary to your plan, you should also create a custodial arrangement.
This is an arrangement in which you select a custodian for the account under the Uniform Gift to Minors Act (UGMA). That law enables a named custodian to have the authority to manage the money in the retirement plan and to do so without court supervision.
What if a child inherits a retirement plan that does not name a custodian? This is certainly a complication. In such a situation, the parents of the child will have to petition the court to themselves be named custodians of the retirement plan. But if the child has no parents – which could certainly be the case if you're leaving the plan to one or more of your own children – the account will have to be managed by a court appointed guardian, who will also be supervised by the court.
Potential Non-Spouse Beneficiary Complications
Non-spouse beneficiary arrangements come with their own set of issues. But there are circumstances that can cause additional complications. Perhaps the most significant situation is where there are multiple beneficiaries on the same retirement plan.
It's not uncommon for people to name both their spouse and their children as beneficiaries to the same retirement plan. But even more likely is when multiple children each inherit a share of the same plan.
If it is a spouse plus one or more children, or even another party, the spouse will lose the simplicity that normally goes with inheriting the retirement plan of his or her spouse.
In addition, if you die before you turn 70 1/2, and therefore had not begun taking RMDs, each beneficiary can separately calculate RMDs, based on his or her own life expectancy.
But the situation can be more entangled if you die after you reach age 70 1/2 and have begun taking RMD's. If you do, the RMD's for each of your multiple beneficiaries will be based on the life expectancy of the oldest beneficiary. Naturally, if your spouse is one of the beneficiaries, the RMD's to the spouse and your children will be based on the life expectancy of your spouse.
This could create a problem for the younger beneficiaries. It will mean that they will have to take withdrawals based on a shorter life expectancy. For example, a 10-year-old child will have to take RMD's that are based on life expectancy of your 40 year old spouse.
This will not only create a potential tax liability for the younger beneficiaries, but it also holds the potential to deplete the account well before the younger beneficiaries reach retirement age. If your plan is to enable your own retirement account to help pay for your beneficiaries own retirements, it may not work out that way for the younger beneficiaries.
Retirement Plan Beneficiaries Don't Have to be People
You don't necessarily have to name specific individuals as beneficiaries of your retirement plans. You can also designate your estate as the beneficiary, or set up a trust for that purpose. However, neither is a perfect option.
If you name your estate as the beneficiary, you are setting up your estate for probate. That means that your estate will have to go through the courts before any money is distributed. And during probate, challenges can be entered against the estate that can change the ultimate distribution of the funds. If individuals are named as beneficiaries on your retirement plans, those accounts will not have to go through probate, and the money will be distributed directly to them according to the distribution plan that you elect.
In addition, if you die before you reach age 70 1/2, all the money will have to be withdrawn in no more than five years. And even if you die after reaching 70 1/2, ultimate beneficiaries of the account will have to take RMDs based on your own life expectancy. Either outcome will create a heavier tax burden than will be the case if you name individual beneficiaries.
The problem with naming a trust as the beneficiary of your retirement accounts is that the beneficiary of the trust won’t be able to move the funds into his or her own retirement account, or name beneficiaries to those accounts in the event of his or her death. In this way, if your spouse is the beneficiary of the trust, she won't be able to pass the accounts directly onto your children upon her death – the accounts will be part of the trust. This will deny them the opportunity to take less frequent RMDs than would be the case if they were based on their own life expectancy. And that of course could result in higher tax liabilities.
There could be a workaround to this dilemma, but only if the beneficiary of the retirement plans is a revocable living trust. In that situation, the RMDs would be based on the life expectancy of the oldest beneficiary of the trust.
That's certainly better than having RMDs that are based on a five year payout. But it’s not nearly as good as the direct individual beneficiary designations that would allow your beneficiaries to spread the RMDs over their own life expectancies.
When it comes to retirement plan beneficiaries, the individual route is almost always better.
Summing Up Non-Spouse Beneficiary Rules
Now that you've seen some of the complications that can arise in non-spouse beneficiary situations, you should review your own retirement plans to see how you have the beneficiary designations set up.
Obviously the simplest way to handle a retirement plan beneficiary designation is to simply name your spouse. But if you don't have a spouse to name, and/or if you have multiple beneficiaries, your best bet is to set up the arrangement in such a way that will result in the fewest complications. If a person is important enough to name as a beneficiary on your retirement plan, then they are also important enough to have it set it up in the most beneficial way possible.
Unfortunately, if you are non-spouse beneficiary to a retirement plan owned by a person who is already dead, you will have no choice but to work with however the designation was established. It's one of those situations where much can be done in advance, but little can be done after the fact.
Please pay careful attention to the beneficiary designations in your own retirement plans. Though it is certainly noble to make someone the beneficiary of your plan, you should want to do your best not saddle them with unnecessary complications and taxes.