Here's What Happens to Your 401(k) When You Die (Most Families Get This Wrong)

When planning for the future, many people focus on building their retirement savings and not as much on what happens to those funds after they're gone. A 401(k) plan will serve you well through retirement, yet countless families don't always know what to do with the account after a loved one's death.

To ensure your family has easy access to what you've left them, it's essential to understand how to properly set up a 401(k) and prepare yourself financially. Here's a look at who inherits your 401(k) as well as common mistakes to avoid.

Who inherits your 401(k)?

Your savings will ultimately be distributed to the person or persons you name as beneficiaries. Setting up your plan works best if you name two levels of beneficiaries:

• Primary beneficiary: This is the first recipient.
• Contingent beneficiaries: These are the backup recipients. They inherit your 401(k) if the primary beneficiary cannot receive the money due to death, unwillingness to accept it, or some other reason. Contingent beneficiaries could be your children, another individual, or a charity.

You must list your beneficiaries, or your 401(k) may become part of your estate and be distributed according to your state's law.

How is a 401(k) distributed when you die?

Your 401(k) funds transfer directly from the account to the named beneficiaries. You can name multiple primary beneficiaries as long as you divide the account among them by percentages that total 100%.

Keep in mind that you can't name anyone else other than your spouse as a beneficiary unless your spouse provides written consent. You can also name contingent beneficiaries who will receive the money if your primary beneficiaries die before you.

As part of required minimum distributions (RMDs), most non-spouse beneficiaries must empty the account within 10 years. Spouses, on the other hand, can roll the 401(k) into their own account and follow standard age-based withdrawal rules.

Alternatively, a spouse can retain the inherited account and make required withdrawals according to their age or the original owner's schedule.

What if there is no beneficiary?

The funds will become part of your estate and be subject to probate, a legal process that oversees the estate of a deceased person.

Some plans designate default beneficiaries in case you don't name them. You may find this information in the appendix or one of the clauses in the base document. Most of the plans name the default beneficiaries as follows, in order of hierarchy:

• Spouse
• Children
• Parents
• Estate

Even if the plan document designates your default beneficiaries, but you don't write their names, the 401(k) will still be subject to probate. The proceeds will then be distributed in the order designated in the document after the probate process. Even if your will says otherwise, the names on your 401(k) plan take priority.

Remember, your spouse will always be the default beneficiary, whether you designate them as such or not.

Is an inherited 401(k) taxed?

Traditional plans only allow you to deposit money on a pre-tax basis. The cash will only be subject to taxes when withdrawn in retirement. As for Roth 401(k) plans, you contribute after-tax dollars, so qualified withdrawals are completely tax-free.

Your 401(k) doesn't face taxes immediately after you die. The beneficiary will be required to pay income tax when withdrawing funds from the account.

Inherited 401(k) plans are subject to these tax rules:

• Lump-sum distributions are treated as regular income.
• Rolling spousal pre-tax money to a Roth account triggers taxes.
• If you're a non-spouse, you'll owe taxes on withdrawals from an inherited traditional IRA funded by a pre-tax 401(k). There's a good chance you'll pay tax to convert a traditional 401(k) to a Roth.
• Withdrawals from a spouse's rollover funds are taxed as ordinary income if you're under 60, unless it's a qualified Roth withdrawal.

You won't pay an early withdrawal penalty if you inherited the plan as a spouse and you're 60 or over.

Common mistakes individuals make with 401(k)s and beneficiaries

You or your beneficiaries may make some mistakes that could prove costly. Here are the most prevalent ones:

Not naming beneficiaries

Don't rely on the default beneficiaries list. Your 401(k) will go through probate if you don't designate one or more. That means a judge will oversee your estate and use your money to pay off your debts, if any, and the cash could end up with someone you didn't plan for, like creditors.

Be sure to keep the beneficiaries updated regularly to ensure the right people receive the cash.

Not thinking through conversions

The IRS allows 401(k) heirs to transfer the money into an inherited Roth IRA. You can't do this if you inherited a traditional IRA, as you must maintain the same tax setup.

If you transfer funds from a traditional 401(k) to a Roth IRA, you'll pay regular income tax on the amount moved. For large transfers, the tax bill could be astronomical and heirs are still required to take RMDs.

Failing to take into account special needs

Some beneficiaries should not receive the funds directly. Minors require a court-appointed conservator to manage the funds, which can be costly. For others, such as individuals with special needs, direct inheritance may result in lost benefits.

Setting up a trust in their name is usually the better option.

How to properly set up your 401(k)

You can enroll in a 401(k) at any time. Some employers do it for you, while others ask you to sign up.

Here's a simple way to get started at your job:

• Consult HR or the benefits portal to create one.
• Determine a contribution amount that suits your budget. If your company offers to match your investment, contribute the maximum.
• Decide between a traditional or Roth, depending on the applicable taxes.
• Choose your investments carefully. For instance, stock funds may offer long-term growth but carry some risk.

Online tools can help you track progress.

Bottom line

Planning for what happens to you and your assets after you die isn't the most comfortable topic, but it's a crucial step to ensure things go your way. By keeping your beneficiary information up to date and leaving a clear plan for your family, you can help ensure your hard-earned savings don't get hung up in the red tape.

Explain to your heirs what they need to do when the inevitable happens, and consider providing them with a written version they can refer to when that difficult time arrives. Taking these proactive steps doesn't just offer peace of mind but also puts you and your family on the right track to build wealth that lasts beyond your lifetime.

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