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danilol
Level 3

tax consequence of different beneficiary of 401k

Could anybody tell me what is the tax consequence between human being and family trust as beneficiary of 401k (or IRA)

For example if I assign person as beneficiary of 401k, only income tax( or estate tax if applicable) will be collected at the time of  withdraw. 

If a family trust be assigned as beneficiary of 401K, then will be collected 35% tax.

I am not sure my understanding is correct or not.

 

 

 

10 Replies
Mike9241
Level 15

tax consequence of different beneficiary of 401k

A trust for a 401(k) account is ideal if any of the following scenarios applies to you:

Your beneficiaries are young children or grandchildren, or a person with special needs.
Your beneficiaries have drinking, drugs, gambling, or creditor problems.
You have remarried and want to ensure your second spouse and/or children receive their due.
Your beneficiaries have poor financial sense and cannot be trusted with a large sum of money.
You don’t want your assets to become part of your spouse’s “estate” – potentially subject to taxation.
It is possible to roll the funds into an IRA to ensure that only the Required Minimum Distributions are paid out to recipients named in the trust, 

The trust document directing that the monies received from the retirement account be distributed is how taxes are avoided at the trust level. 

 

Potential Disadvantages of Designating a Trust as a 401(k) Beneficiary
The assets will be subject to Required Minimum Distributions: The primary disadvantage of naming a trust is that the retirement plan assets will be immediately subjected to RMD payouts, calculated based on the expected lifespan of the oldest beneficiary. When there are multiple beneficiaries, the younger ones will then lose out on their ability to earn deferred interest.
Uncle Sam may want his cut straight away: Employers can prohibit trusts from receiving periodic 401(k) payouts, meaning all the deferred taxes will be due on the full 401(k) balance within one year of your death, when the money is inherited. If your employer’s plan does not permit life-expectancy payouts to a trust beneficiary, you may consider rolling over the 401(k) balance into an IRA that specifically allows it.
You must leave your money to a person: The IRS has rules about trust beneficiaries. For instance, the 401(k) must go to a person or group of people. You can’t, for instance, leave your assets to a charity, your church, or any other non-specific entity. You may also need to designate a contingent secondary beneficiary who will receive the remaining assets should the primary beneficiary die before all funds have been distributed.
Trust setups require a bit of paperwork: Valid trust beneficiaries must qualify under state laws. They must be named specifically in the trust document, and a copy of this document must be filed with the 401(k) plan administrator. Under IRS rules, a will cannot override a beneficiary designation form, so you will want to be sure of your wishes.

 

dmertz
Level 15

tax consequence of different beneficiary of 401k

A trust is not an individual.  Only a 401(k) beneficiary that is an individual is permitted to roll the inherited 401(k) over to an inherited IRA, so if left to a trust the inherited 401(k) is not permitted to be rolled over to an inherited IRA and either the entire 401(k) must be distributed to the trust in a lump sum to be includible in income in a single tax year or the inherited 401(k) will need to be maintained by the plan (if they permit) to allow RMDs and other amounts to be paid out to the trust over more than one year.  Many 401(k) plans do not permit the inherited 401(k) to be maintained and instead require a lump-sum distribution if the beneficiary is not an individual, so check the plan agreement.

 

Unless the intent is to protect this asset with a trust, it's almost always a really bad idea to make a trust the beneficiary of a 401(k) due to undesirable tax consequences.

danilol
Level 3

tax consequence of different beneficiary of 401k

I think your answer explained 35%tax due to a lump-sum distribution in one year as income.

Thank you.

danilol
Level 3

tax consequence of different beneficiary of 401k

@Mike9241 First I do not have any scenarios that you listed in your first paragraph.

So can I understand as : when I considering assign a beneficiary for my 401K, I should choose person first as primary and secondary beneficiary, and choose trust as the last one if no more person available.

The reason to put trust in as the last one if there is still room to put in, (some 401k only allow limited number of  beneficiary to be assigned) is in the case all beneficiaries passed away and the money go no where, then the money can go to trust.

 

Am I correct?

 

Thank you for so detailed answer.

Opus 17
Level 15

tax consequence of different beneficiary of 401k


@danilol wrote:

I think your answer explained 35%tax due to a lump-sum distribution in one year as income.

Thank you.


Yes, trusts have much higher tax rates than individuals 

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
Opus 17
Level 15

tax consequence of different beneficiary of 401k


@danilol wrote:

@Mike9241 First I do not have any scenarios that you listed in your first paragraph.

So can I understand as : when I considering assign a beneficiary for my 401K, I should choose person first as primary and secondary beneficiary, and choose trust as the last one if no more person available.

The reason to put trust in as the last one if there is still room to put in, (some 401k only allow limited number of  beneficiary to be assigned) is in the case all beneficiaries passed away and the money go no where, then the money can go to trust.

 

Am I correct?

 

Thank you for so detailed answer.


You may want to consult an estate lawyer in your state.

 

In general, if you name John as your beneficiary, and John dies before you (and you don't change the beneficiary before you die) then the asset would pass to John's estate (his heirs).  If you name a primary and second beneficiary and they both die before you (and you then die before updating your beneficiaries) the funds will go to the heirs of your secondary beneficiary, cutting out the heirs of the primary beneficiary.  Make sure that's what you want.

 

Example: 

Tom has two sons, John and James, and John and James each have two daughters (Tom's granddaughters).  Tom and John get in a car accident and John dies at the scene, while Tom dies in hospital.  Tom has a 401k with John and James as 50% beneficiaries.  50% of the 401k will go to James, and 50% will go to John's estate, to be divided based on John's will or the laws of intestacy in that state.  So that might mean it all goes to John's wife, or 50% to each daughter, or 50% to John's wife and 25% to each of John's daughters, or something else entirely.  The wife and daughters can rollover the funds to IRAs and pay taxes at normal rates instead of estate or trust rates. 

 

So now Tom needs to think, is that arrangement what he wants?  Maybe Tom wants all the funds to go to the children and cut out John's widow.  In that case, Tom needs to designate contingent beneficiaries.  If the girls are minors, Tom might want to create a family trust, even though the taxes are higher.  (Paying 37% to keep the money safe until the girls are mature enough to handle it might be preferable to paying 22% having the girls waste it on boyfriends and booze.)

 

So you need to talk to your beneficiaries and find out if they have a will, and you need to educate yourself on the intestacy laws of your state. It may be that you only need to designate a primary beneficiary if the operation of inheritance law would put the money where you want it anyway.  

 

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
Mike9241
Level 15

tax consequence of different beneficiary of 401k

basically, you have 3 choices

1) name a person as the beneficiary of your plan and if you want, multiple contingents beneficiaries. some plans may only allow one. but if multiple ones are allowed you can specify the order. read the beneficiary form carefully so you know who will get what. if you are not careful you may specify each of the contingent beneficiaries to receive equal shares rather than one after the other    

2) don't name anyone then it goes to probate to decide who gets it and your estate may get a sizable bill for the tax on the value of the account plus incur probate costs

3)  name a trust as beneficiary, then the trust specifies that any RMD's or other monies taken out of the retirement a/c are to be distributed to the named beneficiaries in the named amounts. even in a trust, a person must be the ultimate beneficiary 

 

from my previous post.

You must leave your money to a person: The IRS has rules about trust beneficiaries. For instance, the 401(k) must go to a person or group of people. You can’t, for instance, leave your assets to a charity, your church, or any other non-specific entity. You may also need to designate a contingent secondary beneficiary who will receive the remaining assets should the primary beneficiary die before all funds have been distributed.
Trust setups require a bit of paperwork: Valid trust beneficiaries must qualify under state laws. They must be named specifically in the trust document, and a copy of this document must be filed with the 401(k) plan administrator. Under IRS rules, a will cannot override a beneficiary designation form, so you will want to be sure of your wishes.

 

so what happens if all the primary and contingent beneficiaries die? then if the trust doesn't handle this situation it ends up in probate. that's why you a competent person to set up the trust properly. Maybe this can be done by the Trust administrator or you may need a lawyer.  

if you're still working you may want to discuss thongs with the human resource department or even the administrator of the plan. 

Opus 17
Level 15

tax consequence of different beneficiary of 401k

If left to an estate, there is no reason for the estate to pay estate tax rates.  The account is passed to the heirs who will pay any taxes at individual rates.  The only reason for the estate to pay any taxes is if the probate is open so long that the estate must take an RMD.  There's no reason for the estate to withdraw all the money, that's bad planning by the executor.

 

 

 

 

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
dmertz
Level 15

tax consequence of different beneficiary of 401k

"In general, if you name John as your beneficiary, and John dies before you (and you don't change the beneficiary before you die) then the asset would pass to John's estate (his heirs)."

 

Nope. 

 

In the example, if John predeceases Tom, John is not designated per stirpes and James is left as the only remaining primary beneficiary, it all goes to James.  If Tom want's Johns issue to be the beneficiary in the case where John predeceases him, Tom would designate John per stirpes.  If Tom wants John's wife to get what would otherwise be John's share, a custom beneficiary designation would be needed stating such, if the 401(k) plan permits custom beneficiary designations.

danilol
Level 3

tax consequence of different beneficiary of 401k

@Opus 17 

Thank you for your example which allow me know more about how will estate be distributed after people death.

 

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