Whether death benefits from a company’s retirement plan are taxable for the beneficiary depends on the type of death benefit as well as the beneficiary’s relationship to the deceased. Company death benefit plans do not go through probate, as the late account owner designated beneficiaries at the time of the account's establishment. So, whether taxable or not, the beneficiary may receive these assets more quickly than nonemployment assets that may have to go through the time-consuming probate process.
TL;DR (Too Long; Didn't Read)
There are a few factors that determine whether or not death benefits from a company retirement plan are taxable, including the kind of benefits and the relationship between the beneficiary and the deceased.
Exploring Life Insurance
Payments to beneficiaries from company life insurance policies are generally not taxed. However, that also depends on the nature of the policy. If a spouse leaves $100,000 to the other spouse, that $100,000 is not taxable. If the life insurance policy earns interest, say $4,000 annually, that amount is taxable. If the beneficiary decides to take the life insurance proceeds as monthly installments rather than a lump sum, it is critical to determine what percentage of each payment is interest and pay tax on the amount accordingly.
Defining Pension Plans
If the beneficiary begins receiving death benefits from a pension plan, this amount is usually taxable as ordinary income. Pension plan beneficiaries usually receive a percentage of the amount of the deceased’s plan benefit, often about two-thirds. For example, if the deceased received $3,000 per month in pension benefits, the beneficiary might receive $2,000. Beneficiaries can arrange to have taxes taken out of their monthly checks if they like, rather than calculating the taxes owed themselves.
Understanding Variable Annuities
If a beneficiary receives a lump sum amount from an employer-sponsored variable annuity after the owner’s death, the distribution is usually taxed only if it exceeds the unrecovered cost of the annuity contract. If you decide to receive annuity payments instead of a lump sum, these distributions are only subject to tax when exceeding the contract’s unrecovered costs.
Evaluating 401(k) Plans
In a 401(k), earnings accumulate tax free until the owner of the account begins making withdrawals. In retirement, most people find themselves in a lower tax bracket than during their working years. A beneficiary inheriting a 401(k) would similarly owe tax on distributions.
If the beneficiary is a surviving spouse, he has options that other heirs do not. A surviving spouse may roll the 401(k) into his own IRA, and he will not be taxed on the distributions until he starts making withdrawals. Owners of traditional IRAs and 401(k) plans must start making withdrawals by the age of 70 ½. The surviving spouse may also leave the funds in his late spouse’s 401(k) plan and begin making withdrawals at the time in which the deceased would have turned 70 ½, with the withdrawals again subject to tax based on his income tax bracket.
Situations With Other Beneficiaries
If the beneficiary is not the surviving spouse, she may leave the 401(k) with the plan provider if the plan allows for this. Such heirs may also roll over the funds into an inherited IRA. Depending on the 401(k) plan, this heir may have to remove the entire amount in the account within five years or take a lump sum distribution.
Other plans may allow the heir to take required minimum distributions each year, as long as the deceased was under age 70 ½ at the time of death. These required minimum distributions are now based on the beneficiary’s life expectancy, not that of the deceased, per IRS tables. A lump sum payment will result in significantly more taxes for the current year if it pushes the heir into a higher tax bracket, while required minimum distributions are taxed at the beneficiary’s ordinary income rates.
State and Other Laws
When it comes to employer-related retirement plans, much depends on the type of plan and the state in which the deceased resided. Some states have specific laws when it comes to beneficiaries and government and other retirement plans. That’s why it is essential to contact the administrator of any retirement benefit plan and get a copy of the plan’s rules. The administrator should answer any questions you have.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.