Lynn Brenner's Family Finance

What If My 401(k) Loses My Beneficiary Designation?

Q: When my employer changed 401(k) plan providers, there was a three-week blackout period during which we couldn't access our accounts.  When I was finally able to get back in to verify everything, I noticed that it stated: 'No beneficiaries have been selected'!  

I quickly rectified that, but noticed there was no place to list contingent beneficiaries. When I asked HR what happened, they said: 'Oh, we are in the process of updating that, but it will take some time.'  I faxed signed paperwork to the administrator to make sure my primary and contingent beneficiary designations were up to date. 

I told HR that if I had died over the past three weeks during the blackout period, with no primary or contingent beneficiary assigned, it's my understanding that my account would gone to my estate, and would have to be distributed as a lump sum to my husband, without him having a chance to convert it into his own retirement account. As a result, he'd have to pay tax on the lump sum! 

The employee benefits officer said 'No, your pension would always go to your husband, and the account could stay in the plan for 5 years,  unless he was over over 70.' He said that under our plan, if my husband was no longer living, my account would automatically go to my kids, who also could keep it in the plan for up to 5 years. He said neither my husband nor my children would have to make any decision about the money for 5 years. 

But even if that's correct, what are the tax consequences? And what if I didn't have a husband or children? --RD

 

A:  These are good questions, and some of the answers are disquieting.

Let's start at the beginning. Every retirement account custodial agreement contains a default provision that governs what happens when there's no designated beneficiary on the account.

In IRAs, that default beneficiary is typically your estate. And if your retirement account defaults to your estate, your heirs must empty the account -- and pay taxes on it -- much faster than if they had been the designated beneficiaries. (I've explained what happens in detail here,  here and here.)

401(k) plans also have a default provision. From what you say, in your plan the default beneficiaries are a) your spouse; and b) your children. "This effectively puts them on the plan as if they were designated beneficiaries, in that order," says Ed Slott, a Rockville Centre tax accountant and IRA expert.

As a result, your surviving spouse (or your kids) would have the same favorable tax options as if you'd designated them on the account: Your husband could roll the account into an IRA in his own name; and your kids could transfer it into Inherited IRAs that retained your name as the owner and listed their own names as beneficiaries, which they could empty over their life expectancies. (You'll find more about that here.)

So in your particular case, the default designation works as you would wish. But in other cases, it can have unintended and potentially costly consequences.

"I saw this situation a few years ago, when a man's 401(k) beneficiary designation was missing when he died," recalls Slott. "Under his plan's default provision, the account automatically went to his surviving spouse. But she was his second wife, and he had wanted the account to go to his kids from his first marriage. They didn't get it."

Besides, as you point out, not every plan participant has a spouse or kids. What happens to the account of an unmarried, childless participant in your company's plan if he or she doesn't have a designated beneficiary? "Their accounts probably default to their estates," says Slott. Whoever inherits the estate will get the 401(k) account, but won't be able to stretch taxable withdrawals over his or her lifetime.

You're also right that naming contingent beneficiaries can be very helpful to your survivors. (This earlier post explains why.) 

The bottom line: Ask your 401(k) plan administrator to send you written confirmation of your beneficiary and contingent beneficiary designations. Keep the plan's confirmation letter where your heirs can find it -- for example, in your safe deposit box, attached to your will with a paperclip.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Can My Husband Get My 401(k) Plan?

Q: My husband wants my 401(k) now, but I don't want to get distributions until I have to. Will he win if he goes through the court system? What is his right to my 401(k), which I opened before I married him? Right now, my daughter is my beneficiary. We have no pre-nuptial or post-nuptial agreement. --MT

 

A: Stop worrying. Your husband has no case to take through the court system. As long as you're alive, he has no legal claim to your 401(k) account. 

In fact, even if you want to take a 401(k) distribution yourself, you can't  do it while you're working for the company that sponsors the plan, unless you qualify for a special hardship withdrawal.

But your husband is legally entitled to be your 401(k) beneficiary unless he has waived that entitlement in a post-nuptial agreement. (Nobody can waive it in a pre-nuptial agreement because it's a right that doesn't exist until after you're married.) In fact, if you didn't give your 401(k) plan administrator a written waiver signed by your husband, the plan shouldn't have let you list your daughter as your beneficiary.

So what are your options if you want to make sure your husband doesn't inherit your 401(k) plan?

You have three choices:

1. You can persuade him to sign a waiver. 

2. As soon as you leave this job, you can transfer your 401(k) account into an Individual Retirement Account. (See my earlier posts on how to do a trustee-to-trustree transfer to avoid taxes.) IRAs aren't governed by the federal law that establishes the rules for 401(k)s. You can name your daughter or anyone else you choose as your IRA beneficiary. 

3. You can divorce your husband.  However, in a divorce he may get part of your 401(k) account even though you opened it before you married him. The reason: In most states, an account you have contributed to during your marriage is considered a marital asset. That makes it subject to division in a divorce. How big a share your husband might get depends on many variables, including how long you've been married and what other marital assets you own.  

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

A Smart Move: Using Inherited IRA to Pay Student Loans

Q: I've inherited an IRA ($75,000) as a result of my Mother's passing. I will get another $30,000 from the sale of her home when it sells, hopefully within the year. I have student loans for a total of $44,000 at interest rate of 7.75% (already consolidated). I am 53 years old and single. I make around $30,000 a year and have a disability with my hands that holds me back.

I am thinking of paying off the student loan with the inheritance money, because I will probably not get that high a return in the market, and because it would be really nice to be out of debt. I am currently in deferment with the loans because I can’t afford the $365 monthly payment. This adds about $100 of interest to the balance every month.

My plan is to immediately pay the loan down $14,000 out of the IRA, and to wait until the house sells and then pay the rest with the money from the sale of the house. I’ve been told that I will not have to pay taxes on the $30,000 because it is part of her estate.  If that is the case, it is better that I wait until the house sells, rather than use the IRA money to pay off the whole loan.

This will get me pretty much debt free, and after taxes I will have $55,000 + left in the IRA. I don’t own a home and have no car payment. I might even be able to save money after that. I'd appreciate any feedback. I want to do what is best for my future, and I can’t afford to make the wrong decision at my age. --WL

A: You've put together a very sensible, well considered plan.

Before suggesting how you might tweak it to make it a little more tax-efficient, let's briefly explain to other readers the points that you already clearly understand.

The basic rule of thumb for figuring out whether to invest money or use it to pay off a debt is to compare the interest you pay on the debt with what you can earn in the investment. Paying off your student loans is risk-free. The only comparable investment would be an FDIC-insured product – and in today’s environment, that won’t return anything close to 7.75%!  (These days, you won't make that by taking on the risk of stocks or bonds, either.)

You’re also right that you won’t owe taxes on the sale proceeds of your mother’s house. Capital assets like houses are inherited at their market value at the time of the previous owner’s death. (If a house is worth $100,000 when you inherit it, for example, you can sell it for $100,000 without incurring any tax.)

But you will owe income taxes on your withdrawals from the inherited IRA. And as I've explained in previous posts, you’re required to take minimum annual distributions from the account, beginning no later than December 31 of the year after your mother’s death. (The required distribution is based on your life expectancy. At 53, the Internal Revenue Service Single Life Expectancy actuarial table gives you 31.4 years. Your annual minimum distribution is the IRA’s balance at the end of the previous year divided by your life expectancy. Let’s say $75,000 divided by 31.4, which would be $2,388.53.)

It's a good idea to use the $30,000 from the house and $14,000 from the IRA to pay down your student loans, says Barry C. Picker, a Brooklyn NY tax accountant and IRA expert. But from a tax standpoint, it would be more efficient to take $14,000 from the IRA in monthly withdrawals than in one shot.

He suggests you make the $30,000 payment first, and then withdraw $365 a month from the IRA to pay whatever loan balance remains. (“And to the extent that you can afford, say $100 a month from your salary, you only have to pull $265 a month from the IRA,” he adds.)

Here’s why:

1. Making monthly payments spreads the income tax burden: If you take $14,000 in a single withdrawal, you’ve increased your taxable income for that calendar year by $14,000. If you divide $14,000 into monthly $365 payments, it boosts your annual taxable income by only $4,368 for three calendar years. 

2. Making monthly payments would cover your required minimum withdrawals for three years. With a single withdrawal, no matter how big, you only satisfy one year’s distribution requirement.

3. Making monthly payments is slightly better for your credit score. If you retire your loans with a single payment, you’ve reduced your outstanding debt. That’s good for your ‘total debt amount’, which accounts for 30% of your credit score. If you retire a debt in monthly payments, you improve your 'credit history', which accounts for 35% of your credit score.

That said, your plan is a good one even if you opt for the less tax-efficient -- but perhaps more emotionally satisfying -- approach and get rid of that debt as fast as possible. If that’s your choice, I certainly won’t fault you for it!   

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved