If you’ve ever spoken with a financial planner or seen an investor checklist in a financial planning article, one of the most commonly recommended items to review is beneficiaries. Most articles don’t give much guidance on how to choose a beneficiary, they just say it’s important to name one.
Choosing your beneficiary is often a deeply personal decision. You may to ensure loved ones who depend on you financially will be taken care of when you’re no longer here. You may have a charity or institution whose mission will be an important part of your legacy.
While beneficiary designations and best practices will vary case by case, here are a few helpful things to consider.
If a spouse inherits your retirement plan, they can treat it as their own account and may not be subject to required minimum distributions right away. In most 401(k) plans, you are often required to name your spouse as the primary beneficiary, unless they sign off on you naming someone else.
Regardless, naming your spouse as primary beneficiary for your retirement accounts often makes financial sense because they have the most flexibility. If the account holder passed away in 2020 or later and left the assets to a non-spouse, they must fully distribute all assets by the end of the 10th year after the year the account holder died.
Beneficiary planning and estate planning go hand in hand. The goal for most of my clients is to distribute assets to their chosen people and organizations in the most efficient way possible. In this case, “efficiency” means in the least amount of time with the least amount of taxes.
While most people want to focus on their taxable income and taxable estate, you also want to consider the taxes your beneficiaries will be subject to. For example, assume you have 40% of your estate in a pre-tax retirement account and 60% in a taxable brokerage account. Let’s also say you plan to split your assets between your two children. Child one is a venture capitalist in the highest tax bracket, and child two is a teacher in a relatively low tax bracket.
From a tax perspective, it would potentially make sense to leave the brokerage account to the venture capitalist (they’ll benefit from a step-up in basis at death on the capital gains in the brokerage account) and retirement account to the schoolteacher (they will be taxed at ordinary income tax rates, but the tax owed will be relatively low compared to the venture capitalist). Considering the tax implications for your beneficiaries can help ensure that more of your assets go to the people you want them to.
If you intend to include a charity in your estate plan, it may be wise to name them as beneficiaries for at least a portion of your retirement account. The charity would not have to pay income taxes on the assets it receives from your retirement account. Also, your assets would pass to the charitable organization, so your estate would be eligible for a federal estate tax charitable deduction on the account's value.
As always, feel free to reach out if you have questions about any of the topics covered here. Happy planning!
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