An important, but often overlooked, aspect of your financial plan is making sure your various account beneficiary designations are in order for your estate. Not only is this estate organization important to make sure your wishes are implemented, it is also important to minimize the efforts required by your loved ones.
Estate planning typically centers around development of a will/trust and other legal documents. Completion of those documents is essential for everyone, but another follow up task that should not be forgotten is proper designation of beneficiaries on retirement and other investment accounts. Many of these accounts, such as retirement accounts, will pass to beneficiaries outside of probate and it is important to properly specify beneficiaries to align with the intent of the will/trust. Additionally, the tax consequences may vary depending upon the beneficiary of each account so it is important to consider which beneficiary might be most appropriate for each of your accounts.
To make sure your beneficiary designations align with your trust/will, you should consult with your estate planning professional and/or your financial advisor. To figure out the best beneficiary for your various account types, there are many nuances that you might want to consider.
Taxable Accounts
For bank accounts, standard brokerage accounts and similar taxable accounts, you don’t typically need to specify a beneficiary. In fact, you might just want to specify your estate or trust to be the beneficiary in order for it to fit better into your estate plan.
A tax advantage of these accounts in your estate is that any unrealized capital gains will receive a “step-up” in cost basis when passed on to the beneficiary. The step-up in basis means the cost basis (i.e., the value considered to be paid for the asset) will reset to the value of the asset on the date of your demise. When you sell an asset, you are taxed on the income generated, which would be the amount of the sale minus the price you paid for it, otherwise known as cost basis. Therefore, the step-up in basis will result in a lower tax bill if the basis is adjusted higher than what you originally paid for it. For instance:
Say you are invested in stock worth $100,000 that you originally purchased for $20,000. If you were to sell this stock during your life, you would owe capital gains tax on the $80,000 of capital gain. However, if this stock gets passed on to your beneficiary, they would receive the stock with a new basis (or assumed purchased price) of $100,000. If they were to immediately turn around and sell the stock, your beneficiary would have $0 in capital gains and thus would not owe any tax.
The reasoning behind the step up in basis is that the estate is considered to have paid any tax due before the asset is passed on to beneficiaries.
Qualified Retirement Plans and Traditional IRA’s
With IRAs and qualified retirement plans, such as 401(k)’s, the rules for beneficiaries start to get more complicated and vary depending upon who the beneficiary is. During your life, these assets are only taxed when you take a distribution from the accounts. Therefore, any remaining assets in these accounts represent income that has not been taxed and the IRS is anxious to get their income tax revenue. Unless your spouse is the beneficiary, the IRS will force early liquidation of the accounts.
If yourspouseis the named beneficiary, your spouse has several options for dealing with the account when it is inherited.
- They can roll funds into an inherited IRA. Distributions from the inherited spousal IRA before age 59.5 are not subject to the 10% early withdrawal penalty. Distributions from the IRA will not be required until you would have turned 72, at which time Required Minimum Distributions will begin. Any distribution taken out of the inherited IRA will be taxed as ordinary income to your surviving spouse, however.
- Your spouse could roll the funds or securities over into their existing IRA. If this option is chosen, the inherited funds mix with any funds already in the account and the entire IRA is subject to standard distribution rules for your spouse.
- If the funds are in a qualified employer retirement plan, the spouse could leave funds in the plan (depending upon plan rules). If funds are left in the plan, withdrawals would need to comply with the plan rules and taxation would follow standard distribution rules based upon the spouse’s age.
The next set of potential beneficiaries are called “eligible designated beneficiaries.” These beneficiaries would fall into one of the following categories:
- Someone who is less than 10 years younger than you
- A disabled beneficiary
- A chronically ill beneficiary
- Your minor child
- Certain trusts (many trusts are not considered eligible designated beneficiaries and trusts can have additional rules that are beyond the scope of this discussion)
These beneficiaries must begin taking distributions from the inherited account the year after your demise but they are allowed to “stretch” the distributions out over their lifetime. The amount of these required minimum distributions are based upon the age of the beneficiary and their life expectancy. Your minor child is handled a bit differently in that they get to “stretch” the distributions until they reach the age of majority, when they become a “non-eligible designated beneficiary” and must follow those rules (see below). Since the IRS is forcing these withdrawals the typical early withdrawal penalties for beneficiaries under age 59.5 do not apply.
All beneficiaries that do not fall into the category of spouse or eligible designated beneficiary are considered “non-eligible designated beneficiaries.” For these individuals, current regulations require that the funds be placed in an inherited IRA and withdrawn within a 10-year timeframe. The distributions can be spread out over that time frame or withdrawn all at once, but all withdrawal amounts will be taxed as ordinary income for the beneficiary. As is the case with eligible designated beneficiaries, early withdrawal penalties for those under age 59.5 do not apply to these distributions.
Roth IRAs/Roth 401(k)’s
Similar to traditional plans, a spousal beneficiary to a Roth account has several options:
- They can roll funds into an inherited Roth. Distributions from the IRA will not be required until you would have turned 72, at which time Required Minimum Distributions will begin. RMD’s would not be taxes since the Roth consists of after-tax funds.
- Alternatively, your spouse could roll the funds into an inherited Roth and then distribute all of the funds within the 10th year after your demise.
- Your spouse could roll funds over into their existing Roth account and the funds would follow the standard Roth rules for your spouse.
- Your spouse could take a lump sum distribution all at once. As long as the account is more than 5 years old, the entire distribution would be tax-free. The downside with this option is that your spouse would lose the benefit of the account continuing to grow tax-free for years after your death.
Eligible Designated Beneficiaries for Roths are classified the same as with traditional retirement plans. Again, these beneficiaries must begin taking distributions from the inherited account the year after your demise. The required distributions are stretched over the life expectancy of the beneficiary but come out tax-free since the Roth contains after-tax funds.
Non-Eligible Designated Beneficiaries must follow the 10-year rule where funds must be distributed within the tenth year following the year of your demise. All distributed funds will be tax and penalty free as long as they were held for 5 years but they must come out of the tax advantaged account during this time frame.
HSAs
In most instances, your spouse is the best HSA beneficiary, and second-best would be a charity. Spousal-inherited HSAs become their own HSA which allow tax-free distributions for qualifying healthcare expenses. Charities inheriting an HSA will receive the funds free of tax.
For all other beneficiaries, inherited HSAs are not very tax friendly. For a non-spouse person, the HSA would be converted to a taxable account and the full value becomes taxable to the beneficiary in the year of transfer. If you were to name your estate as beneficiary, the assets get transferred to your estate and are treated as taxable income on your final tax return.
Summary
Beneficiary designations can be tricky and complicated depending upon the beneficiary and tax status of the account. The information provided herein should be considered general guidance for naming beneficiaries on your various accounts. It is highly recommended that you consult with your financial planner and/or estate planning professional to determine and fully consider the ramifications of your beneficiary designations. The more thought that you can put into the process, the better the outcome is likely to be.