Inheriting 401(k) Assets? New Opportunity Awaits

If you are the beneficiary of a parent’s 401(k) plan, you may be entitled to receive a large lump-sum distribution from the plan. Normally, the 401(k) will require you to take the payout within a year of the plan participant’s death.

New approach: Thanks to a new tax law change, you can now roll over the plan funds into an IRA. This will enable you to stretch out payments over several years—maybe even decades.

The new Pension Protection Act of 2006 gives nonspouse beneficiaries a lot more flexibility than they had in the past. In short, you can use the same rollover technique as a spousal beneficiary. This new law provision takes effect for distributions received after 2006.

Background: When a participant in a 401(k) plan or other qualified retirement plan dies, the plan may require the account assets to be distributed to the designated beneficiaries in a lump sum. A spousal beneficiary can take the distribution or elect to roll it over into his or her IRA. With a rollover, the spouse is able to defer the tax on the payout.

However, prior to the new law, a nonspouse beneficiary was not permitted to roll over funds to an IRA. He or she had to receive the distribution under the plan terms. This could result in a big tax hit over five years or less or even immediate taxation.

With an inherited IRA, a nonspouse beneficiary is obligated to take distributions according to the required minimum distribution (RMD) rules. The exact method depends on whether or not distributions have begun (i.e., if the participant had reached age 70½).

*If distributions had already started, the remaining portion of the IRA assets must be distributed at least as rapidly as the distribution method being used at the time of death.

*If distributions had not yet started, all of the IRA assets must be distributed within five years of death or over the life expectancy of the beneficiary, beginning in the year after death.

The new law permits a nonspouse beneficiary of an eligible retirement plan to roll over the assets to an IRA. From that point on, the rules for RMDs from inherited IRAs apply. So, a beneficiary may choose to spread out the tax payments over his or her life expectancy. The distribution doesn’t have to be taxed immediately as a lump sum. Using the life expectancy method also enables you to benefit from continued earnings within the IRA over time.

Be aware that you must follow the usual tax rules for rollovers to avoid tax complications. For instance, if the funds aren’t directly transferred in a trustee-to-trustee rollover, automatic 20% withholding will apply to the payout. We can provide assistance concerning these complex calculations.

Caution: Don’t commingle the inherited assets with any existing IRA assets. If you do that, you will lose the benefit of stretching out the payments

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