A 401(k) beneficiary is the person (or persons) who will receive the money in your retirement account upon your death. That sounds pretty simple, but there are several things about naming a beneficiary that you should know — especially if you’re married, divorced or considering naming your children as beneficiaries. We will walk you through the ins and outs of picking a beneficiary, as well as what happens if you don’t.

• What is a beneficiary?
• What happens if you don’t name a beneficiary?
• How to pick a beneficiary if…
• When to update your beneficiary
• What taxes will my beneficiaries have to pay on an inherited 401(k)?

What is a 401(k) beneficiary?

When you enroll in a 401(k) plan at work, you’ll often complete a form naming your beneficiaries. You’ll be asked to name at least two people: a primary beneficiary and a contingent (or secondary) beneficiary:

• Primary beneficiary. Your primary 401(k) beneficiary is your first choice to receive your retirement assets in the event of your death.
• Contingent beneficiary. Your contingent, or secondary, beneficiary is the person (or people) who will receive benefits if your primary beneficiary isn’t alive when you die, or declines to accept the benefits.

You may name more than one person in both the primary and contingent beneficiary categories. If you do, though, you’ll need to specify the percentage each primary beneficiary will receive. The shares don’t have to be equal, but the total must equal 100%. For example, you could name a sibling as a primary beneficiary receiving 80% of the account balance, and two charities receiving 10% each.

What happens if you don’t name a 401(k) beneficiary?

Selecting a 401(k) beneficiary might seem like a formality, but it’s incredibly important if you want to have a say in who inherits your account. If you’re married, your spouse is typically going to be the automatic beneficiary of your 401(k), even if you don’t officially name them on the beneficiary form; there may, however, be some exceptions depending on your plan. But if you’re single, or want someone other than your spouse to inherit your account, naming a beneficiary can prevent a lot of trouble for your heirs. Even if your spouse will be your automatic beneficiary, it may be a good idea to fill out the form for your records.

Typically, retirement accounts avoid the probate process and transfer directly to the named beneficiaries. Probate is a legal process in which the court determines whether a deceased person left a will and ensures the deceased person’s assets are distributed according to their will (or according to state law if the deceased person didn’t have a will).

If you don’t have any living 401(k) beneficiaries when you die, your 401(k) can wind up in probate, and several problems can arise:

• State law determines who inherits your assets: If you don’t have a will, the probate court uses the state intestate laws to decide how to distribute your assets to heirs.
• Probate can be costly: The cost of having your assets go through probate varies depending on your estate’s size and makeup, state laws and whether you have a will. However, between court fees, appraisals and attorney fees, probate costs usually range somewhere between 2% to 5% of the value of your assets that go through the process. You can reduce those costs (and ensure more of your assets go to your heirs) by keeping your 401(k) out of the probate process.
• The transfer of assets may be delayed: If you have a valid beneficiary for your 401(k), your beneficiary can receive the account relatively quickly once your financial institution receives proper notification of your death. The probate process, on the other hand, can take months or even years.

How to pick a beneficiary if…

You’re married

If you’re married, 401(k) beneficiary rules typically consider your spouse as the default beneficiary of your account. Even if you want your spouse to inherit the account and the process will be automatic, your plan administrator might ask you to complete the beneficiary form just as a formality.

If you want to name someone other than your spouse as your beneficiary, your spouse will usually have to sign a spousal waiver agreeing to it. You can get a spousal waiver form from the firm that administers your employer’s 401(k) plan, and the waiver typically needs to be witnessed by a notary or a plan representative.

For example, say you’re married and you don’t want to name your spouse as a 401(k) beneficiary because they are already financially well off. Instead, you’d like to leave the account to your child from a previous relationship. Your spouse must agree to sign the waiver — if they don’t sign the waiver and you list your child as the sole beneficiary, your spouse will still inherit the account, regardless of what your beneficiary designation says.

You’re single

If you’re not married, you can name anyone as your beneficiary without having to have extra documents signed. This could be your children, your parents, siblings, a friend or a favorite charity.

Just remember to update your beneficiary designation if your situation changes. For example, if you name your parents as beneficiaries and they die before you do, you’ll need to update your beneficiary designation to name someone else. If you get married later on, your spouse will likely automatically take precedence over anyone else named as a beneficiary. Thus, you’ll probably need to have them sign a spousal waiver if you want to keep your beneficiaries as is.

Your kids are underage

If you want to name a minor child as a beneficiary, you should consider consulting with an estate planning attorney first. Most 401(k) plans will not transfer money directly to a minor. Instead, a court will have to appoint a trustee or guardian to receive the funds, which can take some time.

There are a few ways to avoid this, and your options may depend on the laws in your state. Some states allow parents to name a minor as a beneficiary and a custodian who will manage the assets in the child’s best interest until they reach a certain age — usually 18 to 25, depending on the state.

Another option is to create a trust. When you create a trust, you also name a trustee who will manage trust assets on behalf of your child — either until they reach a certain age or for their lifetime. Then you would list your child’s trust as your beneficiary. In either case, it’s a good idea to consult with an attorney first to make sure you’re not unintentionally jeopardizing your child’s inheritance.

When to update your beneficiary

You should update your beneficiary designations any time you have a major life event, such as marriage, divorce, separation, a death in the family or the birth or adoption of a child. Of course, it can be difficult to remember to update paperwork amid major life events. For that reason, it’s a good idea to make reviewing your 401(k) beneficiaries something you do annually.

If you do need to update your beneficiary, it will likely take only a few minutes. Most plan custodians allow you to change your beneficiary online in just a few minutes, or print out the paperwork necessary to do so. If you can’t find instructions on your plan’s website, check with the benefits department at your workplace to get the beneficiary designation form and a spousal waiver (if needed).

What taxes will my beneficiaries have to pay on an inherited 401(k)?

Typically, inheritances aren’t taxable income as far as the IRS is concerned (although some states have an inheritance tax, and there is a federal estate tax for very large estates). But that’s not always the case with inherited 401(k) accounts.

If you have a traditional 401(k) (not a Roth account), then your account’s contributions have not yet been taxed. You funded the account with pre-tax income or employer contributions, and the earnings on those contributions have not been taxed either. As a result, when your beneficiary takes withdrawals from the account, those distributions are considered taxable income, and they will need to pay income tax.

Before Jan. 1, 2020, 401(k) heirs had the option of “stretching” payments — and thus the related tax bills — over their life expectancy. But the Setting Every Community Up for Retirement Enhancement (SECURE) Act changed that — now, beneficiaries have to withdraw assets from an inherited 401(k) within 10 years after the account holder’s death.

There are some exceptions:

• Surviving spouses: A surviving spouse can roll inherited 401(k) funds into an IRA without paying taxes on it. Distributions from that IRA will be taxable when they start taking them in retirement.
• Disabled or chronically ill individuals: If your beneficiary is disabled or chronically ill, they can take taxable distributions over their lifetime.
• Minor children: If your beneficiary is a minor child, they must withdraw funds from the inherited 401(k) within 10 years of reaching age 18.
• Beneficiaries who are less than 10 years younger than the original account owner: This allows beneficiaries (such as siblings, for example) to stretch distributions over their lifetime.

If your beneficiary falls into one of these exception categories, they should talk to a financial advisor or tax professional before withdrawing any funds to ensure to take advantage of any potential tax planning or saving opportunities.

Naming a beneficiary for your 401(k) might seem like an inconsequential part of saving for retirement, but think carefully about who you want to inherit your account if you pass away unexpectedly — then be sure to update your beneficiary forms when things change.

While both tax avoidance and tax evasion may sound like something that could get you in trouble with the IRS, tax avoidance is legal, while tax evasion is not. Tax avoidance means taking steps to lower your tax bill. Tax evasion, on the other hand, is deliberately paying less than you legally owe.

You’ll learn more below about the difference between tax avoidance vs. tax evasion, and how to avoid having the IRS target you for not paying your fair share.

• What is tax avoidance?
• What is tax evasion?
• The difference between tax avoidance and tax evasion
• How to avoid tax evasion

What is tax avoidance?

Tax avoidance involves taking deductions, credits and other tax breaks that you’re eligible to claim. So is tax avoidance legal? Yes: Many taxpayers use tax avoidance strategies to lower their taxable income and liability, and it’s perfectly legal. After all, lawmakers created the tax rules that help qualified taxpayers reduce their tax obligations. So if you’re wondering how to not pay taxes legally, tax avoidance is how you can do it.

Tax avoidance can take many forms: It might include minimizing your taxable income, maximizing tax credits and deductions or controlling the timing of income and deductions.

Some specific examples of legal tax avoidance strategies, otherwise known as tax loopholes, include:

• Making tax-deductible or pre-tax contributions to retirement accounts, such as 401(k)s and IRAs
• Investing in U.S. savings bonds or municipal bonds that earn tax-exempt interest income
• Making charitable donations that qualify for a tax deduction
• Claiming the Earned Income Tax Credit or the Child and Dependent Care Credit
• Prepaying state and local taxes in December, even though they aren’t due until after year-end, so you can deduct them in the year paid
• Postponing a year-end bonus until the following year because you expect to be in a lower tax bracket next year
• Deducting business expenses, such as the business use of your home

What is tax evasion?

Tax evasion is a type of tax fraud that involves intentional, illegal attempts to not pay or underpay the taxes you owe.

Tax laws are complicated, and anyone can make a mistake on their tax return. If the IRS catches your error, it will send you a notice suggesting a correction. If that correction means you owe additional taxes, the IRS will charge penalties and interest on the amount you underpaid.

However, there’s a big difference between making an honest mistake and wilfully committing tax evasion.

Here are a few examples of what’s considered tax evasion:

• Intentionally underreporting or omitting income: You own a business, and clients pay you via cash, check and credit card. You report the income you receive from checks and credit cards on your tax return because you know there’s a paper trail, but you leave out the income you receive in cash, assuming the IRS can’t trace it.
• Claiming fake or improper deductions: You’re self-employed and claim personal expenses such as commuting costs, meals, concert tickets, clothing and home decor as business expenses.
• Falsely allocating income: In addition to your full-time job, you have a side hustle selling handmade home décor. When you make a sale, you ask your customer to make the check payable to your elderly mother, who is in a lower tax bracket.
• Improperly claiming tax credits: You take the Earned Income Tax Credit by claiming that your child lives with you more than six months out of the year, even though your child lives with your ex-spouse full time.
• Concealing assets: You earn interest from a bank account in a foreign country, but you don’t report the account to the IRS or pay taxes on the interest income.
• Not filing tax returns: You try to avoid paying taxes by simply not filing a tax return.

Tax evasion penalties

In addition to collecting the back taxes owed, tax evasion penalties can involve hefty fines and even jail time.

According to the IRS Code, if you’re convicted of felony tax evasion:

• The IRS can fine you up to $100,000 ($500,000 in the case of a corporation)
• You can be sentenced to up to five years in prison
• You may be ordered to pay for the costs of your own prosecution

According to the United States Sentencing Commission, in the 2019 fiscal year, 65% of tax fraud offenders were sentenced to prison, and the average jail time for tax evasion was 16 months.

The difference between tax avoidance and tax evasion

How to avoid tax evasion

It costs the IRS time and money to investigate and prosecute tax evasion cases, so they usually reserve those resources for big-time tax cheats.

Tax evasion investigations can originate from several sources:

• Computer screening: Something about your tax return sends up a red flag in the IRS system, and you receive a notice that the IRS intends to audit your tax returns for a recent number of years (per the IRS, it’s generally the last three years, but no more than six). During the audit, the auditor finds evidence that causes them to believe that you knowingly and willingly evaded your tax obligations.
• Related examinations: The IRS audits one of your business partners or someone else you have a financial relationship with, and that audit leads them to you.
• Tips from the public: The IRS accepts reports from individuals who believe another taxpayer isn’t complying with the tax laws.
• Referrals from other agencies: The majority of tax fraud investigations start when the IRS receives information about possible tax evasion from other federal, state or local agencies or the U.S. Attorney as part of that agency’s investigation into another criminal matter.

Typically, the IRS isn’t going to try to prosecute you for tax evasion if you overestimated the value of your charitable donations by a couple hundred dollars one time. They’re usually looking for large amounts or a pattern of tax dodging that stretches over several years.

As long as you’re not willfully engaging in income tax evasion, your chances of facing tax evasion charges are pretty slim. In fact, in the 2019 fiscal year, the IRS initiated only 1,500 tax fraud investigations and recommended prosecution for 942 cases. Considering the IRS processed more than 253 million federal tax returns and supplemental documents that year, the percentage of taxpayers who face tax evasion charges is very small.

Still, if you’re worried about tax penalties or winding up on the wrong side of an IRS audit, be sure to familiarize yourself with federal and state tax laws, and consider turning the job of preparing your return over to a reputable professional — either online or in person. Professional tax preparers are required to keep up with changing tax laws, and their expertise can help you take advantage of tax avoidance strategies without committing income tax evasion. A financial advisor firm may have tax professionals available to help you lower your taxes while ensuring you are still adhering to all state and federal tax law.