Many Americans make this 1 mistake with their 401(k)s and IRAs. Here's how to avoid leaving a headache for your heirs

Here’s why you need to review your beneficiary designations and ensure your retirement accounts are properly prepared for transfer to your heirs. Plus, we’ll discuss what you need to know about tax implications, account transfers, spousal waivers, and more.

Why beneficiary designations are harder to fix than wills

Accounts like IRAs and 401(k)s were designed to be governed by beneficiary designations, not by your estate plan.

In other words, the beneficiary you listed on your IRA or 401(k) will get the money, whether or not that’s what you’ve laid out in your will. If you don’t list a beneficiary, the funds will likely go to your estate.

The reason for this rule is a good one, in theory. It allows your retirement accounts to bypass the probate process (which can tie up inheritances for up to a year) and instead pass tax benefits to your heirs quickly. (1) The funds also get special tax treatment. However, this is why you must make sure your documents are up to date.

For example, spouses who inherit an IRA or 401(k) can roll that money into their own account. Depending on how old the deceased account holder was, the spouse may be able to delay taking required minimum distributions (RMDs) until they turn 73, letting that money grow tax free for longer. (2)

Children who inherit an IRA or 401(k) don’t have the advantage of rolling the money into their own retirement accounts, and generally they can either take the money as a lump-sum payment or keep the money in a tax deferred account and take distributions for up to 10 years before the account must be liquidated.

The rules for the distribution of funds from inherited IRAs and 401(k)s can be complex depending on the heir’s relationship to the deceased.

For example, spouses have to waive their rights to a 401(k) even in the presence of a beneficiary designation, so if your situation is complicated, it’s best to make plans with the help of a professional money manager.

Once an account holder dies, beneficiary forms are final. Even court orders or family agreements rarely override them. Per the agreement you signed with your financial institution, they are legally obligated to pay the listed person, not whoever is named in the will.

Unlike wills or trusts, which can be contested or amended, beneficiary designations are essentially carved in stone.

How to protect your beneficiaries from expensive errors

The costs of not getting your beneficiaries right on your IRA or 401(k) are high. A single error in naming or maintaining beneficiaries can lead to tax penalties, family disputes and lost inheritances.

If no beneficiary is named, the rules that govern the plan will revert to a default order: usually the spouse first, then children, parents, and the estate, in that order.