Time to Designate Beneficiaries to your 401k
Your Solo 401k is the best vehicle for accumulating tax-free and tax-deferred retirement funds but a time will come when your wealth must be distributed to heirs. The first step in the process is a very personal decision about who your beneficiaries will be. Just as you’ve taken action to minimize your taxes, you’ll want to keep taxes low. Next step in the inheritance process is taking action to transfer as much of your wealth to beneficiaries in a tax-advantaged manner.
“A beneficiary can be any person or entity the owner chooses to receive the benefits.”
There can be special circumstances involving your Solo 401k. One is that you have an operating business as the source of a considerable amount contributions each year. Your business may or may not need to cease operations (not required), but a Solo 401k may not remain active if the business is not operational.
You may also have assets inside your Solo 401k that need periodic attention, such as rental properties. For anyone other than your spouse, they inherit the assets inside the Solo 401k, not the plan itself.
When a Spouse is the Solo 401k Beneficiary
If you and your spouse work in your business together, the business might not need to cease operations. If your spouse continues the business, he or she may generally continue with the same Solo 401k plan. There will probably only need to be some administrative changes such as making the spouse the trustee of the Solo 401k.
However, let’s discuss that your spouse is the primary beneficiary and does not have a business of their own. The beneficiary will need to roll over those assets into another retirement plan.
But first, let’s consider the primary rights of a spouse to your retirement plan.
Let’s Discuss Primary Rights
To start with, it is key understand that your spouse is likely automatically beneficiary of your Solo 401k. That is unless there is written spousal consent to state otherwise. Solo 401k is governed by federal law, the Employee Retirement Income Security Act of 1974 (ERISA). (There may be some exceptions. For example, the spouse may have to be married to the employee for a certain amount of time). When there is no surviving spouse, the plan is added to your estate and distributed according to the terms of your will unless you have designated other beneficiaries to your 401k.
Note: Surviving spouses are treated differently under Solo 401ks than with IRAs. While a Solo 401k provides protections for a surviving spouse, an IRA does not. If you have an IRA and want your spouse to be its beneficiary, you must specifically name your spouse as a beneficiary. The same applies if you roll your Solo 401k over into an IRA – make sure you fill out a new beneficiary designation form.
As the beneficiary of your Solo 401k, your spouse has these options:
- Rollover the Solo 401k funds to his or her own Solo 401k if he/she is self-employed or transfer to another qualified plan.
- Transfer the Solo 401k funds to his/her own IRA.
- Transfer the Solo 401k funds to an inherited IRA (beneficiary IRA).
- Take a full distribution.
Children and Other Solo 401k Beneficiaries
Divorces and remarriages have become common in our society. After a remarriage, it’s common for a Solo 401k account owner to change the beneficiaries to be the children from a previous marriage. But that is probably not enough to assure all the account assets go to the children. Even if a new beneficiary form designates only the children, under ERISA, the new spouse is entitled to 50% of the assets. If you want your children to receive all the assets, the answer to this is to assign them as beneficiaries AND have the new spouse sign a Spousal Waiver. The spousal waiver is also needed if another person or entity (such as an estate or trust) is listed as a beneficiary.
Children and other non-spousal beneficiaries generally have these options after they receive a distribution because of the Solo 401k owner’s death:
- Accept the distribution as ordinary income and report it on their tax return. Regardless of age (even younger than 59 ½), the beneficiary will not have to pay an early distribution tax. The penalty is waived for inherited plans.
- Roll the distribution into a traditional IRA but special rules apply. The beneficiary must title the new IRA in the name of the deceased with themselves designated as the beneficiary. Non-spouse beneficiaries may not rollover Solo 401k plan assets to their own IRAs or to qualified plans such as their own Solo 401k plans.
- Consider using ten-year averaging.
Ten-Year Averaging vs Ten-Year Distribution Rule
Do not confuse ten-year averaging with the ten-year distribution rule. According to the ten-year rule, funds from a non-spousal inherited Solo 401k must be distributed by the end of the 10th year following the year of death. Under the SECURE Act, these distributions must empty the entire account within 10 years of the death of the original account holder. The SECURE Act’s distribute-within-a-decade rule applies only to inherited IRAs whose original owners died after Dec. 31, 2019. IRAs inherited before that are grandfathered in, and the old stretch rules continue to apply. The beneficiary needs to comply with the ten-year rule, otherwise the penalties for not taking the distribution are stiff.
Ten-year averaging is only available to a small segment of taxpayers. Individuals must be born before January 2, 1936 to qualify for the current ten-year forward averaging rules set by the IRS. Ten-year averaging only applies to a lump-sum distribution. Using ten-year averaging, the lump-sum distribution is treated for tax purposes as though it had been spread out evenly over ten years. By spreading a lump-sum distribution over ten years, individuals are generally able to remain in a lower tax bracket. However, in some cases, there may be drawbacks to forward averaging. The current ten-year forward averaging policy uses a calculation based on 1986 tax rates. The top bracket in 1986 taxed at 50%, so high earners may not benefit from forward averaging.
What Applies to Me?
Neither ten-year averaging nor the ten-year rule has to apply. The beneficiary’s current tax rate relative to the future is an important consideration, as is their current financial situation. Let’s say the beneficiary expects his/her tax rate to remain the same as it is currently, the ten-year averaging method may be the best approach. On the other hand, if the beneficiary expects their tax rate to decrease (such as retiring), he/she probably wants to wait to take the distributions during a period of lower taxes. If the tax rate is expected to increase, taking a lump sum now is probably the best answer (before the tax rate increase happens).
Investing the inheritance should be a factor in the beneficiary’s decision. This could be a good opportunity for the beneficiary to use the after-tax inheritance to open a Roth Solo 401k. Thus, the earnings become tax-free at retirement.
Estate planning can become more complex as wealth grows. Here are some more resources that might help:
- Succession Planning and the Solo 401k
- How Can the Solo 401k Invest in Life Insurance?
- Charitable Remainder Trust: Protect Your Solo 401k Assets
- Favorable Tax Deduction: Charitable Giving Trusts
- Why Do I Need a Contingent Successor Trustee?
- Can Your Solo 401k Have a Non-Spouse Trustee?
Also, a Supreme Court ruling worth noting. It stated inherited retirement accounts do not offer the same protection from creditors in the event of bankruptcy, a lawsuit, or other situations as do regular Solo 401ks, and other retirement accounts. If you think this might be an issue, you may prefer other estate planning vehicles, such as a trust. Consult your financial advisor or estate planning professional.