Picking a retirement plan beneficiary is a key step in estate planning. Every year we hear about people who lost out on enormous tax savings by picking the wrong beneficiary. So how do you decide whom to pick?
Most married people will choose their spouse. This is usually a good idea because the spouse can take distributions from the plan if he or she needs the money. The spouse can also roll the account over into his or her own retirement plan.
But what if you’re unmarried, or your spouse has passed away, or you are choosing a contingent beneficiary in case your spouse passes away before you do?
The ideal beneficiary may be a young person. That’s because if certain rules are followed, the young person can establish an “inherited IRA” and spread withdrawals from the account over his or her life expectancy.
Since a young person will typically have a longer life expectancy, he or she can stretch the withdrawals out over many years or decades, allowing the assets in the account to grow tax-deferred the entire time. This can result in an enormous tax – benefit.
An older person can also be a good choice, but since their life expectancy is not as long, they will have to make larger withdrawals from the account and the tax savings will not be as great.
It’s generally a bad idea to name your estate as the beneficiary because typically all the money will have to be withdrawn (and income tax paid on it) within five years, destroying the chance for a longer “stretch out” and more savings.
If you want the beneficiary to b e a trust, then you should be careful. Unless the trust is specially drafted for this purpose, all the money will probably have to be withdrawn within five years.
It can be a good idea to make charitable bequests out of retirement plan, since you are giving the charity assets that would be subject to income tax (in addition to estate tax) if you left them to anyone else.
As you can see, there are many complexities to choosing a beneficiary and the choice should be made in conjunction with a larger estate plan so there will be a coherent strategy for what happens to your assets.