Who is the beneficiary of your 401k or IRA?

This oversight could cost your loved ones dearly.

Something seemingly so easy as to declare the beneficiary of your 401k has caused heartache for many unsuspecting heirs, who are unintentionally left with nothing.

Take the case of Ben Langford, who worked at a privately owned company for 25 years.  He named his wife of 38 years the beneficiary of his 401k account in the event he died before her.  As it turned out, however, she died first.

Consequently, Ben smartly updated his account, naming his three grown children as the co-beneficiaries of his account.

One year before he was to retire, Ben remarried.  Then, after just a few months and just weeks before the 64 year old was to retire, he died.   His children from his first marriage rightfully began the process of claiming the assets.  Much to their surprise they were denied by his employer.  Ultimately, it was left up to the courts to determine the rightful owner of the money.  Here’s the issue:  Under the terms of the company’s 401k plan, if an employee dies, the employee’s spouse is the rightful heir to the account assets, unless the spouse has waived his/her rights in writing.  The wife, having not signed a waiver, won the right to the assets in court, thus disinheriting the children.  Tragically, Mr. Langford’s well intended wishes were not carried out.

With the boom of 401k and IRA assets in recent years, combined with the fracture of many marriages, this sort of thing has played out in more and more courtrooms around the country.  Most people don’t realize the complexity of the rules governing 401k plans.  You are asked to name a beneficiary when you open the account and that usually is the last time we think about it.  But it is a good idea to reevaluate it periodically, especially if you’ve recently divorced or experienced other life changes that would prompt you to rethink your choices.

Let’s take a look at a few rules governing retirement accounts:

Rule #1:  To designate someone other than your spouse, that person must be named on the beneficiary form, and the spouse must have previously signed a waiver relinquishing any right to the assets. One of the most common financial planning mistakes is failing to change your beneficiary after a divorce or when you remarry.  It is not enough to specify in a will that you want someone else to inherit your 401k.  Your spouse is the presumed beneficiary of your account upon your death, regardless of who is listed as your beneficiary.  Note: These plans are governed by the federal Employee Retirement Income Security Act, or ERISA.  According to this law, spousal rights can begin immediately upon marriage or no later than a year after marriage, depending on the 401k plan.  And only a spouse can waive the right to 401k assets, not those who are engaged.

Tip #1:  If you are considering remarrying and want to make sure you direct the assets to your children from a previous marriage, consider transferring the 401k to an IRA (many plans allow this at age 59 1/2) where you have more flexibility to name beneficiaries and are not hamstrung by the 401k ERISA rules.

Rule #2:  If you are single when you die, your 401k plan assets will pass on to the individual(s) you designated on your form, regardless of what your will says or anyone else who stakes claim to the assets.  So if you have made any other agreements with other family members, make sure the beneficiary designation reflects your intentions.

A recent ruling by the Supreme Court highlights the perils of not updating the beneficiary.  In this case, a married couple divorced after a long marriage.  As part of their divorce decree, the now ex-wife waived her rights to any of his retirement benefit.   He died having never remarried, and most importantly, never changed the name of his beneficiary to his daughter with whom he had agreed would receive the money.  The Supreme Court unanimously ruled to give the money to the person named as the beneficiary even though it was his ex-wife, and even though she had waived any right to the assets.  So as simple as it sounds, if you get a divorce and even if your wife relinquishes her rights to the 401k assets, make sure you update the beneficiary post haste.

Tip #2:  Assuming you have changed the beneficiary to the children, you might want to carefully        consider their age.  Most plans will not transfer assets directly to a minor.  Rather a court would appoint a trustee or guardian to receive the money.  Consider naming your children’s trust as your beneficiary.  This may even apply to grown children if there are concerns about their ability to manage a large sum of money.

Rule #3:  If you are single when you die, and have not designated a beneficiary, the company retirement plan rules may dictate where the money goes.  Most likely it will end up in your estate.  This no doubt will delay benefits to potential heirs as it works its way through the legal process.  This usually happens when the spouse predeceases the plan participant, leaving an undesignated beneficiary.

Tip #3:  Make sure you list both a primary and contingent beneficiary.  If your primary dies before you, or if you and the primary die in an accident, the money will pass to the contingent beneficiary and not the state.

Rule #4:  Spouses have no ERISA rights to IRA benefits, since IRAs are less restrictive than 401ks.  IRAs are subject to state law, which means you generally can name anyone you like as the beneficiary with or without your spouse’s consent.  Certain restrictions apply for those in community property states like Texas.  There was a case several years ago in which the husband opened an IRA two years into a marriage to his new wife.  He named his four children from his previous marriage as beneficiaries.  Upon his death a couple of years later, his current wife contested the claim by the children.  She argued that this money was originally from her husband’s 401k and thus rightfully hers.  The court ruled in favor of the children.  Another notable distinction between IRAs and 401ks:  If you designate your spouse as the beneficiary of your IRA and then get divorced, the ex-spouse would then have no claim to the assets when you die, as the designation would then become null and void in most states.  This is a distinct difference to the 401k which would automatically default to the listed beneficiary being the ex-spouse.  In fact, in most cases, you will have to complete a new beneficiary form if you get a divorce and still desire to have the assets left to your ex-spouse.

While 401k and IRA beneficiary designations seem innocent enough, lack of attention to this simple task can cause incredible hardship and emotional distress to your heirs.  Just imagine how your children would feel if you forgot to remove your ex-spouse as beneficiary, and their intended inheritance gets taken away.

Tip #4:  Make sure you are taking all of the right precautions to leave your children one of your biggest assets, your 401k plan.

As we head into a new year, no doubt you will soon be reflecting on 2014 and vowing to accomplish some new goals in 2015. Make one of these goals to take a quick peek at your beneficiary designation(s).  Add it to your list of tax preparations so you won’t forget.  Your heirs will thank you for it.