Setting up a retirement account beneficiary is an essential part of financial planning. It may be hard to think about a future where you are not in it, but we cannot predict the future – this is why it’s best to be prepared.
This guide will help you understand retirement account beneficiary planning and the difference between per stirpes and per capita elections.
For all of your 401k, Traditional IRA, Roth IRA, and other retirement accounts, you have the option to designate a beneficiary. The primary beneficiary designation determines who will inherit those funds upon your death. Most retirement accounts also allow you to list a contingent beneficiary, which lists who will receive the funds if the primary beneficiary predeceases the account holder.
If you are married, the standard option is to choose your spouse as the primary beneficiary. The reasoning behind this is that if you were to pass away, your husband or wife would receive those funds for their retirement.
Since the assumption is that you and your spouse are planning to retire together, you will likely have to file additional paperwork if you wish to assign someone other than them as the beneficiary. This extra paperwork usually includes a notarized form that states that your wife or husband is okay with the fact that they have not been chosen as the primary beneficiary for the retirement account.
This requirement also applies if you would like to list a second primary beneficiary alongside your spouse. These rules vary by state, but those that are designated as Community Property states, such as California and Arizona, will require written spousal consent if they are not your IRA beneficiary.
If the owner of the 401k is not married, there is state may be listed as the default beneficiary.
Let’s assume that you have $1 million in your retirement account, and your spouse is listed as your primary beneficiary. If something were to happen to you, and your spouse was still alive, he or she would receive the $1 million in your retirement account.
In this case, there is no confusion because there was only one course of action – your spouse inherits the entire amount because they are listed as your sole IRA beneficiary.
You may be thinking, I have a will, so why do I need to name a beneficiary on my 401k or IRA?
Choosing a primary beneficiary – and contingent beneficiaries – is the only way to ensure that your funds are allocated according to your wishes. Even if your will says that you would like your retirement account to be split equally between your two children, if only one of them is listed as the beneficiary they will be the sole custodian of the funds.
In other words, the name listed on the beneficiary designation supersedes any other directive in your estate plan! This is why it is so important that you take the time to review these regularly and ensure that they reflect the most current information.
There have been many court cases where children did not receive a portion of their deceased parent’s IRA because they were not listed as the beneficiary, so you should always update the designation anytime there is a change in family status.
Even if you’re 401k account has automatically designated the primary beneficiary as your spouse, you should review it because the default options do not always reflect your current preferences.
For instance, most of us assume that you or your spouse will predecease the other, which is why they are named the primary beneficiary. As difficult as it may be to think about, what would happen if you both tragically died at the same time in a car accident?
State law addresses the issue of simultaneous death and will have procedures in place to determine which spouse died first. however, proper documentation for successor beneficiaries can eliminate any confusion should this unfortunate situation ever arise.
In addition to listing primary and contingent beneficiaries, estate planning best practices suggest that you indicate whether you would like your retirement account to be distributed per capita or per stirpes.
Keep reading below to understand the difference between the two options:
The per capita designation is usually the default option for your retirement account beneficiary. The term is Latin for “by head” and requires that all living beneficiaries receive an equal share of the retirement funds.
If you select this standard option and one of your beneficiaries passes away before you, their share of the inheritance will be divided equally among your successor heirs.
As a result, a portion of this money will not be set aside for the deceased beneficiary – instead, their portion will be split equally among the remaining members of the group.
Consider you have a retirement account, and the 401k beneficiaries are listed as your son and daughter. If they are listed as 50/50 beneficiaries, and you had $1 million in the account when you died, they would each receive $500,000.
What would happen, though, if your daughter died before you did?
In that case, under the per capita distribution, your son would receive her 50% share, which would result in him receiving an inheritance of $1 million at your death.
Your daughter’s children would not receive anything because they were not explicitly stated as a beneficiary – and the per capital rule determines that the surviving member, your son, will receive a pro-rata portion of her share.
In this example, we’ll assume you have your four kids, Sarah, Nicole, Jake, and Bob. They are listed as your primary beneficiaries for your $1 million 401k account that will be distributed per capita.
If they all survive you, upon your death, the account will be split equally into four parts. Sarah, Nicole, Jake, and Bob will each receive 25% of your retirement account – or $250,000 each.
If Sarah passed away before you, the other three children will receive an equal share of her portion. Sarah and her heirs will not receive anything, but Nicole, Jake, and Bob will receive an equal portion of her 25%. This results in the surviving children inheriting 33% of your 401k, or $333,333 apiece.
As you can see, per capita distribution does not address the fact that Sarah’s spouse and children will not receive any of the funds left in your IRA, even if that was the intention in your will!
Although per capita distribution tends to be the default allocation for 401k beneficiaries, it is not the only option.
Per stirpes is a Latin term that translates to “by class” or “by representation.” Rather than grouping the beneficiaries by the person, it looks at each living beneficiary as a class of people that will receive an equal share.
To put this in simpler terms, if one of your beneficiaries dies before you do, their children or immediate relatives will inherit their portion of funds from your IRA instead. This option ensures that the share of funds you designated to this person will always go to them or their heirs.
The thinking with this designation is that you would have wanted the deceased beneficiary to have access to those funds to support their family and lifestyle – so why shouldn’t their heirs receive it if they can’t?
Remember when you had your son and daughter as 50/50 beneficiaries for your IRA? If you designate the distribution as per stirpes, their respective family lines will receive 50% of the account – even if they happen to die before you.
The flow chart below shows that even though your daughter died before you do, her 50% portion of your retirement account does not automatically go to your son. Instead, her daughter – your granddaughter – will receive the half that you intended her to inherit.
We know life is not always that simple, so let’s look at the per stirpes beneficiary distribution process in a more complex scenario.
Here you have your four children, Sarah, Nicole, Jake, and Bob, getting an equal share of your 401k account. None of your children have kids except for Sarah, who has two sons: Johnny and Billy.
If Sarah passes away while before you, her share does not get evenly distributed to your other children. Instead, your grandsons Johnny and Billy will split her 25% allocation, leaving them with $125,000 – or 12.5% – each.
Now we can analyze the same scenario, but instead of Sarah predeceasing you, we will assume that Jake did. Remember that he had no children, so there is no one else to take on his share of the retirement account. This results in the surviving children, Sarah, Nicole, and Bob, taking on his portion of the inherited funds.
Here, the grandchildren do not receive any of the funds because Sarah is still alive to inherit the money.
Think of per stirpes distribution as a way to cover all aspects of your family situation so that you do not have to alter your estate planning documents each time a new grandchild is born or an original beneficiary passes away.
For this reason, per stirpes is the most common option for estate planning. If you do not want this to be used for your estate plan, be sure that you explicitly state this to your attorney. Similarly, if you opt-out of this option, you have to adjust your plan any time a beneficiary dies before you do.
There is no right or wrong option when it comes to choosing per stirpes or per capita for your IRA beneficiary designation. The key is to analyze your specific family situation and circumstances to determine which route is best suited for your needs.
Don’t leave this to chance! Making a thoughtful decision when naming beneficiaries is an important part of your financial planning foundation and flows right into proper estate planning. Your designations should be reviewed annually at a minimum, or at any time you experience a major life change.
If your kids are your primary beneficiaries and your grandchildren are old enough to make financial decisions and handle an inheritance, perhaps selecting the per stirpes option will be an easy decision to make. If the grandchildren are minors, on the other hand, you may want to work with a financial planner that can help you understand your options and design a custom plan.
Another reason that per stirpes maybe a better distribution option for you is if your intention was for your beneficiaries’ heirs to receive the money, to begin with. Creating a path for funds to skip generations can be a useful estate planning tool but be careful to consider all of the tax implications associated with generation-skipping funds.
Again, if this is the case, your best bet is to partner with a financial planning expert that can help you thoroughly analyze your situation and determine the best course of action.
If you have read through this guide and are concerned that you did not select the right options for your IRA beneficiary designation, do not fret. You can always change your beneficiaries, and the process of doing so is quite simple.
All you need to do to revoke a current beneficiary and designate a new one is to submit a change of beneficiary form to your IRA or 401k custodian. The same process can be used to list contingent beneficiaries and draft customized designations that address unique situations.
Each time you change or update a 401k beneficiary, ask for a confirmation that the retirement account custodian or administrator received it. In most cases, the beneficiary designation will only be considered binding if the responsible party received it before the IRA owner dies.
If you have any questions about your retirement account beneficiary designations or other aspects of planning for your retirement, please get in touch and let me know how I can help.