A nonspouse beneficiary is generally named when the 401(k) participant is not married or if he/she is married and the participant’s spouse has waived his/her rights to the benefit. The most common occurrence of a spouse waiving a benefit takes place when there are children from a prior marriage and when one or both spouses would like to make sure those children receive the 401(k) plan’s proceeds.

Current law treats a beneficiary (for distribution purposes) who happens to be a partner in a same-sex marriage (recognized by six states¹ and the District of Columbia) as a nonspouse beneficiary, and thus he/she has more limited transfer options that a nonspouse beneficiary has.

Our Q&A focuses on issues we understand to be commonly asked questions by plan participants and their financial advisors. The questions and answers that follow are not meant to be tax or legal advice nor address every possible scenario. Each scenario described presents a unique set of circumstances; therefore, if any one is changed, a different answer may result.

You must review your plan’s terms and contact the plan’s administrator with any questions. Decisions regarding beneficiary options may have significant tax consequences, and we strongly recommend that you consult with your financial advisor and/or tax professional.

Q. As a 401(k) plan participant, who can you name as your account’s beneficiary?
A. You can name anyone you want as your beneficiary (married participants need spousal consent), including children, parents, your life partner, relatives, and friends, and even nonpersons, such as charities.

The plan sponsor can provide you with a paper or electronic form on which you make the designation, and it then becomes your obligation to keep it up to date as your situation changes. For example, if you were single when you initially completed the form, and subsequently marry, your spouse will automatically become your beneficiary, even though you named someone else (unless your spouse consents otherwise). Some plans do have a provision that stipulates that a participant needs to be married for at least one year before a spouse has the right to be your beneficiary.

If you do not name someone as your beneficiary, many plans have default rules, which could create a beneficiary designation for you, such as your estate, which may not be what you desire.

Q. When a participant dies, what options does a nonspouse beneficiary (includes married same-sex beneficiaries) have with regard to the late participant’s 401(k) account balance?
A. A nonspouse beneficiary can inherit up to 100% of a late participant’s 401(k) account. He/she generally has three options as to what to do with the proceeds:

1. Leave the money in the plan

2. Transfer the money to an IRA, or

3. Take the proceeds in cash.

If a beneficiary decides to leave the money in the plan or transfer the proceeds to an IRA (called an “inherited IRA”), the beneficiary must make a decision as to how and when to take distributions from the account. Generally, a beneficiary must determine whether to 1) take a minimum distribution, which may be required to begin in the year following the original account holder’s death and continue each year thereafter or 2) defer distributions until a later date, but then the account must be fully distributed by December 31 of the fifth anniversary of the original account holder’s death. Some plans may not offer lifetime distributions and default to the five-year payout, so it is important to understand the plan’s rules and call the plan administrator with any questions.

If a nonperson, such as a charity, is also named one of the 401(k) plan participant’s beneficiaries, it is imperative to have the nonperson’s portion distributed by September 30 of the year following death, or human beneficiaries will be locked into the five-year payout rule.²

A nonspouse beneficiary may also direct that the proceeds of the participant’s account be transferred to an inherited Roth IRA account, opened in the decedent’s name for the beneficiary’s benefit. This is the only way, other than inheriting a designated Roth 401(k) account, that a nonspouse beneficiary may establish a Roth IRA with 401(k) proceeds. If the account is transferred to a traditional IRA rollover first, a Roth conversion cannot occur. The nonspouse beneficiary would also need to determine how to have distributions made from the inherited Roth IRA account as we described above.

A spouse beneficiary may take possession of the 401(k) proceeds for up to 60 days and then complete the rollover to an IRA. A nonspouse beneficiary does not have this ability, and once assets are distributed, they cannot subsequently be rolled over to an IRA.

Q. What is a minimum (nonspouse) distribution from a qualified plan?
A. Whether there is only one beneficiary or multiple ones, the calculation methodology for the minimum distribution amount is the same. Differences may arise, however, in what life expectancy to use in the calculation, as this depends on the ages and types of beneficiaries named. Distribution minimums are governed by regulations under Internal Revenue Section 401(a) (9).

A simple way to look at this is to determine the age of the oldest or only beneficiary in the year following the death of the original account holder. That age has a corresponding life expectancy factor, which the IRS publishes in Publication 590. For example, the life expectancy of a 45-year-old beneficiary is 38.8 years. The account balance total at the end of the prior plan year is divided by this factor to determine the minimum distribution amount for that year.

Let’s say the hypothetical account balance is $200,000. The minimum distribution amount would then be $200,000 ÷ 38.8 or $5,154.63. Each beneficiary would receive a portion of this dollar amount based on his/her inherited share percentage. So if the original account holder had named two beneficiaries to share the account equally, each beneficiary would receive $2,577.32.

The process is the same each year as the life expectancy factor is reduced by one (37.8, in this case) while the account balance is adjusted for earnings (losses) and the prior distribution. The beneficiary would be wise to name his/her own beneficiary to receive the balance of his/her payments (or the account balance) should he/she not survive the full payout term. A new beneficiary takes up where the last one left off, so if the beneficiary in this hypothetical example passed away after receiving one payment, his/her beneficiary would use the 37.8 factor (38.8 – 1) to determine how large a minimum must be distributed, followed by using 36.8, 35.8, 34.8 etc. A beneficiary generally can accelerate how much he/she will take if the minimum is not sufficient for their needs.

The beneficiaries might also each choose to roll the proceeds over to separate inherited IRA accounts (as described above). As long as the beneficiary established the separate inherited IRA prior to December 31 in the year following the original account holder’s death, the beneficiary is able to utilize his or her own age and perhaps lower the minimum to be received, since younger ages have longer life expectancies.

Q. What happens if you name a minor as your beneficiary?
A. When minors are named beneficiaries, the rules governing the minimum distribution requirements are exactly the same. A 12-year-old sole beneficiary would use a 12-year-old life expectancy (70.8 years) when determining the initial minimum. The issue of naming a minor beneficiary, however, can become problematic, as the plan sponsor cannot distribute the proceeds directly to a minor.

To accommodate this situation, it would likely be ideal, from the plan administrator’s perspective as well as the late participant’s, to have the participant create a trust for the benefit of the minor that would be named as the beneficiary or designate a guardian in his/her will who would be responsible for the minor’s interests. Otherwise, the plan could not make any distributions from the account until a guardian is authorized by the probate court before making a distribution.

Your Next Step
As you have just read, some items can be quite complex, while others somewhat simple. Your situation may not be typical of anything we’ve discussed. We strongly suggest you review all beneficiary options with your advisor, your intended beneficiary, and your tax professional.