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NOV
07
Beneficiary Designations for Traditional IRAs and Retirement Plans

Beneficiary Designations for Traditional IRAs and Retirement Plans
(Part 1)


What is it?

If you have a traditional IRA or participate in an employer-sponsored retirement plan such as a 401(k) plan, you are generally required to complete a beneficiary designation form with the IRA custodian or plan administrator. As you may know, the beneficiary or beneficiaries you name (you can generally name more than one) will receive the remaining funds in your IRA or plan account after you die. What you may not realize is that your choice of beneficiary may have implications in other important areas, including:

• The size of the annual required minimum distributions (RMDs) that you must take from the IRA or plan during your lifetime

• The rate at which the funds must be distributed from the IRA or plan after your death

• The combined federal estate tax liability of you and your spouse (assuming you are married and expect estate tax to be an issue for one or both of you)

Because of these and other issues, choosing beneficiaries for your IRA or plan is often a significant financial decision. This is particularly true if your financial situation is complicated, and if your retirement accounts make up a substantial portion of your total assets. It is in your best interest to select proper beneficiaries with the help of a tax advisor and/or other qualified professionals.

Your financial and personal circumstances will likely evolve over time, and you are often free to add or remove beneficiaries whenever you want (though certain restrictions may apply, as discussed below). You should periodically review your beneficiary choices to make sure they are still the right choices.


Tip:
Employer-sponsored retirement plans include qualified stock bonus, pension, or profit-sharing plans. A 401(k) plan is a type of employer-sponsored retirement plan. If you are unsure if you participate in an employer-sponsored retirement plan, ask your employer. This discussion also applies to you if you are a schoolteacher or an employee of a tax-exempt organization or state or municipal government and participate in an eligible Section 457 plan or a Section 403(b) plan.


Caution:
This discussion does not apply to Roth IRAs. Roth IRAs have their own special beneficiary designation considerations.


The law may limit your choices

You are often free to name any beneficiaries you choose for your IRA or plan, but there are exceptions. If you are married and want to name a primary beneficiary other than your spouse, there may be restrictions on your ability to do so. No matter which state you live in, federal law may require that your surviving spouse be the primary beneficiary of your interest in some employer-sponsored retirement plans (such as 401(k) plans), unless your spouse signs a timely, effective written waiver allowing you to name a different primary beneficiary. You should consult your plan administrator for further details.


IRAs are not subject to this federal law, although your state may impose its own requirements. For example, if you live in one of the community property states, your spouse may have legal rights in your IRA regardless of whether he or she is named as the primary beneficiary. In addition, if your roles are reversed (your spouse is the IRA owner or plan participant, and you the primary beneficiary) and you die first, state law may prevent your surviving spouse from changing the beneficiary designation after your death (unless you grant your spouse the power to make these changes in a will or other document). You should consult an estate planning attorney for details regarding these and other state issues.


Your choice of beneficiary usually will not affect required minimum distributions during your lifetime

Under federal law, you must begin taking annual RMDs from your traditional IRA and most employer-sponsored retirement plans (including 401(k)s, 403(b)s, 457(b)s, SEPs, and SIMPLE plans) by April 1 of the calendar year following the calendar year in which you reach age 70½ (your "required beginning date"). With employer-sponsored retirement plans, you can delay your first distribution from your current employer's plan until April 1 of the calendar year following the calendar year in which you retire if (1) you retire after age 70½, (2) you are still participating in the employer's plan, and (3) you own five percent or less of the employer.

Your choice of beneficiary will not have an impact on the calculation of RMDs during your lifetime in most cases. An exception exists if your spouse is your sole designated beneficiary for the entire distribution year, and he or she is more than 10 years younger than you. Also, your choice of beneficiary can impact the tax deferral and other consequences for your beneficiaries.


Caution:
The calculation of RMDs is complex, as are the related tax and estate planning issues. Consult a tax professional.


Your choice of beneficiary will affect required distributions after your death

After your death, your IRA or plan beneficiary (or beneficiaries) will generally have to receive the inherited retirement funds at some point. Distributions from an inherited IRA or retirement plan are referred to as required post-death distributions. With some exceptions, these distributions must begin by the end of the year following the year of your death.

Caution: Your beneficiary generally must withdraw any distribution required for the year of your death if you haven't yet taken it.

For federal income tax purposes, post-death distributions are generally treated the same as distributions you take during your lifetime. (State income tax may also apply.) The portion of a distribution that represents pretax or tax deductible contributions and investment earnings will be subject to tax, while the portion that represents after-tax contributions will not be. Your beneficiary's income tax bracket will determine how heavily the funds are taxed after your death. This may be something to consider when choosing your beneficiaries.


Caution:
Special rules apply to distributions from Roth 401(k), 403(b), and 457(b) accounts. Qualified distributions from these Roth accounts are totally free from federal income taxes. A distribution to your beneficiary will be qualified if your account has satisfied a five-year holding period that begins on January 1 of the year you made your first Roth contribution to the plan and ends after five full calendar years. Even if you haven't satisfied the five-year holding period at the time of your death, distributions to your beneficiary will still be tax free if he or she waits until the date you would have satisfied the five-year holding period before taking distributions from the Roth account. If your beneficiary receives a nonqualified distribution from a Roth account then the portion of the distribution that represents your Roth contributions will be tax-free, and the portion that represents earnings (if any) on those contributions will be subject to income tax. (Additional rules apply to spouse beneficiaries who roll over assets from an inherited Roth account to their own Roth account, or to a Roth IRA.)

In addition, different types of beneficiaries will have different post-death options and be subject to different payout periods. The payout period is important because the longer the funds can remain in the IRA or plan, the more time they have to benefit from tax-deferred growth. Also, a longer payout period spreads out the income tax liability on the funds over more years. In most cases, an individual designated as a beneficiary can take post-death distributions over his or her remaining life expectancy. The younger the individual, the longer the payout period. A surviving spouse can generally use this method, but often has other options as well (such as the ability to roll over the inherited funds to the spouse's own IRA or plan). Special post-death rules apply if you name a trust, a charity, or your estate as beneficiary.

Caution: Nonspouse beneficiaries cannot roll over inherited funds to their own IRA or plan. However, a non-spouse beneficiary can make a direct rollover of certain death benefits from an employer-sponsored retirement plan to an inherited IRA (traditional or Roth).


Be aware that your beneficiaries will be subject to a federal penalty tax if required post-death distributions are not taken, or not taken in a timely manner. The penalty tax is equal to 50 percent of the undistributed required amount for a given year. This is the same penalty tax that applies when lifetime RMDs (see above) are not taken by the applicable deadline.


Finally, the important point is that who or what you name as your beneficiary is crucial because it will ultimately determine how the funds are paid out after you die, and what portion is lost to taxes. Estate taxes may also be a factor to consider if you expect the value of your estate and/or your spouse's estate to exceed the federal applicable exclusion amount.

Caution: In the case of a retirement plan account, the plan may be able to specify the post-death distribution options available to your beneficiaries. Those options may or may not be identical to the allowable options set forth in the IRS distribution rules. You should consult your plan administrator for details, as this could have an impact on your choice of beneficiaries.

Caution: When evaluating whether to initiate a rollover always be sure to (1) ask about possible surrender charges that may be imposed by both the distributing plan and the receiving plan, (2) compare investment fees and expenses charged by your IRA (and investment funds) with those charged by your employer plan (if any), and (3) understand any accumulated rights or guarantees that you may be giving up by transferring funds out of an employer plan.

Content provided by Broadridge Communications



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