Understanding what happens when inheriting retirement accounts

A beneficiary is any person or organization designated to inherit assets when someone dies. Trusts, estates, wills and life insurance policies all have beneficiaries — as do many annuities and pensions. But you're most likely to encounter beneficiary designations when opening a tax-advantaged retirement account like an IRA.

It’s important to name beneficiaries: Should you die without naming beneficiaries, your account could pass into probate — a lengthy legal process that will slow or even prevent distribution of your savings to your heirs, with possible tax consequences. In most states, a surviving spouse automatically inherits a retirement account that has no designated beneficiary.

What is a contingent beneficiary?

Retirement account administrators usually ask you to name primary and contingency beneficiaries. A contingent beneficiary receives the benefits of an account if the primary beneficiary dies, cannot be reached or disclaims (refuses) the inheritance.

Typically, your spouse would be your primary beneficiary, and your children would be your contingent beneficiaries. That means if you and your spouse die at the same time, your children would inherit your account, which would be divided according to the percentages you have assigned. Accounts inherited by minors are typically managed by court-appointed custodians until the children reach adulthood.

Keep in mind that you can have more than one primary beneficiary (called co-beneficiaries). These co-beneficiaries would share the inheritance based on the percentages you have set.

Does my spouse have to be my primary 401(k) beneficiary?

While you are free to choose a primary beneficiary other than your spouse, most company-sponsored 401(k) plans require that your spouse sign a consent form if they are not listed as the primary beneficiary, and some states require the same with IRAs.

If you’re single and without children, beneficiaries could include friends, relatives or charitable organizations — it’s up to you.

Inheriting a 401(k) or other retirement account

Although spouses can generally transfer inherited accounts into their own names, children and other beneficiaries must follow different rules. These rules differ depending on the kind of retirement account inherited.

Inheriting a 401(k) account

Any beneficiary can close an inherited 401(k) and take a lump-sum distribution, without penalty, at any age. However, they will pay income tax on the withdrawal, which could put them in a higher tax bracket.

Spouses and minor or disabled children who inherit 401(k) accounts can take annual distributions over the course of their lives. The set amount of these distributions is determined using IRS life expectancy tables. Most other beneficiaries are required to empty an inherited 401(k) account within 10 years by taking withdrawals every year.

Inheriting a traditional IRA

Anyone who inherits a traditional IRA can take a lump-sum, taxable distribution. Spouses can roll an inherited IRA into their own IRA and wait until they turn age 72 before taking required minimum distributions (RMDs). Or they can remain the beneficiary of the inherited IRA, which could mean taking RMDs right away if their spouse died at age 72 or older. The best choice depends on the age of both spouses at the time of the account holder’s death.

The rules for non-spouses with regard to inheriting a traditional IRA are very similar to the applicable 401(k) account rules noted above.

Inheriting a Roth IRA

Anyone who inherits a Roth IRA can take a lump-sum, tax-free distribution if the account has been open for at least five years. Spouses who are sole beneficiaries, and some heirs like minor or disabled children, can take RMDs over their lifetimes. Most non-spouses, however, must empty an inherited Roth IRA within 10 years.

A final word on beneficiaries

Ensure your beneficiary designations continue to reflect your wishes by reviewing them at least annually and making changes as necessary. Also make sure your heirs know about your retirement account(s) so they can contact the appropriate financial institution(s) when you die. And if you have inherited a 401(k) account or an IRA, consider consulting with a financial professional to make sure you manage those assets in a way that’s best for your unique situation.