The Importance of Selecting A Beneficiary On Your Retirement Accounts For Estate Planning Purposes

One of the biggest mistakes that people make in their estate planning is failing to select a beneficiary for their 401k, IRA, and other retirement accounts. Or worse, they select their estate as the beneficiary. These decisions can have unfortunate results during the administration and distribution of an estate.

The most damaging result of such a choice is that the funds of the retirement account will be accessible by creditors. Through the uncertainty of real estate and equities markets and the inevitable spend-down of funds in retirement, the possibility of an insolvent estate is very real, even for responsible individuals. When an estate is insolvent creditors have priority over beneficiaries. However, when someone has selected an individual beneficiary for a retirement account, the funds will be transferred directly and creditors will probably not be able to access them. Selecting an estate as beneficiary, or failing to select a beneficiary, wastes this opportunity to protect assets.

Another unfortunate result from failing to select a beneficiary is that the timeline to withdraw all of the funds after death is much shorter than if a beneficiary is selected (approximately 5 years versus timelines based on the actuarial life expectancy of the decedent or beneficiary). This compacted timeline allows for a much shorter period for tax-free growth.

Additionally, if someone wishes to leave significant funds to charity, retirement funds can be an ideal way to achieve that goal in a tax-efficient manner. Upon distribution to an estate or an individual from a retirement account, income tax is due. But if a charity is the beneficiary, it is not required to pay such tax. Therefore, the total amount actually given to beneficiaries and charities is greater when a charity is a direct beneficiary of a retirement account.

When selecting an individual as a beneficiary, a spouse is usually the best selection due to the special rule that allows a rollover directly into that spouse’s existing accounts. This result defers any income tax until the spouse makes distributions, which are not required until age 70 1/2. It also reduces the hassle of creating and handling new accounts.

In making these beneficiary designations one should also be sure to leave enough liquid assets in the estate to cover payment of estate and inheritance taxes (which are applicable to retirement account funds), funeral expenses, and other necessary expenditures by the estate.

Nevertheless, the opportunity to pass large amounts of money outside of the estate is one that people should not neglect. While retirement accounts are not a way to avoid estate and inheritance taxes, a simple online selection of a beneficiary is usually all that is needed to reap the substantial benefits set forth above. We strongly advise discussing the issues surrounding the selection of the beneficiary on your retirement accounts with an estate planning attorney and with your accountant.

Pidgeon & Pidgeon, P.C. provides estate planning services in New Jersey and Pennsylvania.

This article is for informational purposes only and is not intended as legal advice. You should consult your estate planning professional before taking any actions outlined above.