You've worked hard all your life and perhaps have accumulated money in a retirement plan such as an employer-sponsored 401k plan. You might want to consider what happens to your 401k assets after you die because you can make decisions now that affect how the plan assets are distributed after you pass and how your beneficiaries will be taxed on the amounts they receive.
Naming a Beneficiary
Federal regulations automatically designate your spouse to be your 401k beneficiary. You can't name a different beneficiary unless your spouse signs a form waiving her right to inherit your 401k. If your spouse waives the form, or if you are not married, you can name whomever you like as your beneficiary including relatives, friends, trusts and charities. If you name no one, your estate inherits the 401k, which means it will be distributed under a court proceeding known as probate, a time-consuming process.
Spouse as Beneficiary
Spouses who inherit a 401k plan have several options. Some employers allow spouses to continue in the plan, but many insist on making a lump-sum distribution to the surviving spouse. Spouses who inherit a traditional 401(k) plan can rollover the plan assets into an IRA without incurring immediate taxation. The rollover must be done as direct rollover between the 401k and IRA trustees if they want to avoid taxes. A spouse can instead take the 401k proceeds as a lump sum and pay taxes on it all at once. Alternatively, the spouse can take the proceeds in installments that stretch out for five years or over the spouse's lifetime. Your tax consultant can explain your options, which depend in part on your spouse's age at death, your current age, and whether or not your spouse was receiving payments from the 401k.
It is less likely that the employer-sponsor of a 401k will allow a non-spouse beneficiary to remain in the plan after your death. The plan proceeds will either be distributed as a lump sum or possibly stretched out over a five-year period. If you name one or more children under age 18 as beneficiaries, the state will require the money go into a trust that oversees it until the beneficiaries reach 18. This can take a long time to work out after your death, but you can shorten the process by naming a trust as the beneficiary.
A trust is a legal arrangement in which a named person or organization, known as the trustee, administers assets on behalf of beneficiaries. You can name a trust as your 401k beneficiary, but you must be very careful about it. Only certain types of trusts are acceptable under federal rules, so you might want to speak with a trust attorney first. You can set rules on how and when the funds in the trust will be distributed to beneficiaries, whether they are minors or not. This gives you some control over your beneficiaries. For example, you might withhold a child's access to the trust until she graduates college or satisfies some other condition.
Some 401ks are set up as Roth plans, meaning contributions were made with after-tax money. That means distributions from the Roth 401k are tax-free to you and your beneficiaries. Your beneficiaries cannot roll over an inherited Roth 401k into a traditional IRA, but they can transfer the funds to a Roth IRA.