A 401(k) or an IRA can help you leverage your savings and defer a lot of income tax in your lifetime. But what happens to 401(k) or IRA money when someone dies? Does it matter if you inherit a 401(k) instead of an IRA?
The answer used to be that a non-spouse beneficiary would be much better off inheriting an IRA than a 401(k). This is because an IRA can be “stretched” to permit the beneficiaries to maximize income tax deferral benefits. With a properly set up IRA, the beneficiaries can simply take advantage of the IRS rules that allow them to stretch the IRA by only withdrawing an amount based on their life expectancy each year. They still have to pay income taxes on the amounts withdrawn, but it’s much smaller than in a non-stretch IRA. This means a lot more money stays in the IRA than it otherwise would so income taxes are deferred for a much longer period of time. This can be a huge income tax benefit to the beneficiaries and can permit them to use the IRA as part of their own retirement plans.
In the recent past, money left in a 401(k) to a beneficiary other than a spouse could rarely be stretched. It was almost always better for your family if you rolled out your 401(k) into an IRA at retirement. Even though you may have enjoyed the investment options or other aspects of your 401(k), leaving your money there used to almost always leave less flexibility and a much larger income tax bill for any beneficiaries other than your spouse.
The IRS has recently changed the rules and a 401(k) should now offer flexibility to a non-spousal beneficiary, although there may still be more of a “hassle” than with an IRA. In 2007, the IRS ruled that, in some circumstances, a beneficiary of a 401(k) may be able to roll it out into an “inherited” IRA that can be created after death. This means, if you inherit a 401(k) and you are not the spouse, you may have an option to turn it into an IRA and stretch it.
In the first round of 2007 changes, it appeared that the IRS only permitted a 401(k) to be stretched if the plan sponsor allows a plan-to-plan transfer. If it did, you would initiate a direct rollover, get the money into an IRA and enjoy the stretch provisions. If the plan sponsor did not offer the option, you were out of luck. Later in the year, the IRS issued further guidance which appeared to require plan sponsors to permit plan-to-plan transfers.
In short, it now appears that plan sponsors must permit plan-to-plan rollovers. Also, timing is very important, since all matters must be completed by the end of the year following the year of death and sometimes sooner. This new IRS flexibility will hopefully permit more beneficiaries to experience the tax flexibility previously available mostly to those inheriting an IRA. If a plan sponsor denies eligibility for a plan-to-plan transfer, the 2007 IRS rulings and guidance discussed above should be reviewed since the benefit to the beneficiary can be tremendous.
For further information regarding these matters, please contact Ms. Umphrey at 248.619.2591 or [email protected]
Cynthia Umphrey helps families and business owners make significant personal and professional life decisions. Ms. Umphrey calls upon over 10 years of experience in estate planning, probate administration, business structuring and business exit planning to guide you though life's most important choices.