Choosing Beneficiaries to Maximize Assets (and Minimize Taxes)

Insurance policies, IRAs, and other retirement accounts require you to name beneficiaries to inherit your assets. Understanding the many tax and legal consequences surrounding beneficiary designations is imperative. Keep the following points in mind when choosing your beneficiaries.

A Will Does Not Control Your Assets

Life insurance, IRA, and retirement plan disbursements pass directly to the beneficiaries named on the contract, regardless of what your will might say. This is good for your beneficiaries, but it also means you must keep your beneficiary designations up-to-date.

Beneficiaries of Retirement Assets

Spouses are the default beneficiaries of retirement plans. If you are married, federal law states your spouse is automatically the primary beneficiary of your pension plan, 401(k) plan or other retirement plan. If you choose to name someone else as a beneficiary, 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. The surviving spouse can continue the tax deferral and take the annual required minimum distributions based on his or her single life expectancy.

IRAs and Beneficiaries

Your beneficiaries can distribute the benefits of your IRA based on their life expectancy. If you name your children or grandchildren as beneficiaries, they will be able to stretch the distributions and tax benefits of your assets for years to come. This strategy is often referred to as a “Stretch IRA.”

Insurance Policies and 401(K)s

Proceeds from insurance policies are free of income tax. No matter who you designate as beneficiary on life insurance policies, the proceeds are generally distributed free of federal income tax. Insurance proceeds do not automatically go through probate.

Each 401(K) plan sets its own rules for non-spouse beneficiaries. Some may use the same rule that applies to IRAs. Many cases require the distribution to be taken in one lump sum one year post-death and is taxed as ordinary income.

Minors as Beneficiaries

Avoid naming minor children as beneficiaries. Generally, pension plans, IRAs, and insurance policies will not pay death benefits directly to minors. Instead, a child’s guardian receives the proceeds on the minor’s behalf. To simplify the process of receiving proceeds, consider naming a child’s guardian or a trust as the beneficiary.

Keep your beneficiary designations current and review them regularly. 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.