Choosing Beneficiaries Wisely and with Taxes in Mind
Insurance policies, IRAs, and other retirement accounts all require that you name beneficiaries who will inherit these assets. Understanding the many tax and legal consequences surrounding beneficiary designations is important, not only in terms of leaving a legacy, but also in ensuring that estate and income taxes don't unintentionally erode assets meant for loved ones. Here are some important points to keep in mind.
A will does not control these assets. The disbursements from life insurance, IRAs, and retirement plans pass directly to the beneficiaries named on the contract, regardless of what your will may say. This is good for your beneficiaries; it also means that you must keep your beneficiary designations up-to-date. Spouses are the default beneficiaries of retirement plans. If you are married, federal law states that your spouse is automatically the primary beneficiary of your pension plan, 401(k) plan, or other retirement plan. In fact, if you choose to name someone else, your spouse must consent in writing. This rule usually makes good tax sense, as the surviving spouse can generally roll the assets over into their own IRA, continuing the tax deferral and taking annual required minimum distributions based on his or her single life expectancy.
Beneficiaries of IRAs can take distributions based on their own life expectancy. This strategy is often called the "Stretch IRA"; when children or even grandchildren are named as beneficiaries, they can stretch the distributions of these assets -- and tax benefits -- for years, even decades, beyond your death. Regarding 401(k) plans, each plan sets its own rules for non-spouse beneficiaries. Some may use the same rule that applies to IRAs, but in many cases the distribution is required to be taken in one lump sum the year after death and is taxed as ordinary income.
Proceeds from an insurance policy are free of income tax. No matter who is designated as beneficiary on life insurance policies, the death benefit proceeds generally will be distributed federal income tax free. Unlike property disposed of in a will, insurance proceeds do not automatically go through probate.
Avoid naming minor children as beneficiaries. Generally, neither pension plans, IRAs, nor insurance policies will pay death benefits directly to minors. Instead, a child's guardian will eventually receive the proceeds on the minor's behalf. The key here is "eventually." To make the process of receiving proceeds a smooth one, consider naming a child's guardian or a trust (set up for the benefit of your children) as beneficiary.
Keep designations current. If you haven't reviewed your beneficiary designations lately, it's time to do so.ght be surprised to find that you've named someone as beneficiary who has passed away or you have omitted your youngest child simply because he hadn't been born when you opened the account.
By selecting the right beneficiary, or combination of beneficiaries, you can greatly extend the potential value of your assets and reduce the amount paid in taxes.