Avoiding a Tax Bite on Inherited IRAs and 401(k)s

Like life insurance, beneficiaries of individual retirement accounts (IRAs) and workplace accounts (401k, 403b and 457 plans) inherit the proceeds directly without having to go through probate court. And IRAs and 401(k)s have become popular in many estate plans in recent years because they are not subject to probate costs.

But unlike life insurance, inherited tax-deferred accounts can trigger a big tax bill for beneficiaries if they transfer the funds to their banks before they talk to their accountants or financial advisers, SFGate.com reports. Customer service reps at banks may not be trained to handle these issues.

Inheriting an IRA
The least complicated situation occurs when a spouse inherits an IRA. The spouse can treat it as his or her own either by becoming the named owner of the account or by rolling it over into the spouse’s own IRA. The spouse can then make contributions to the IRA and must take minimum required distributions. The spouse may also roll over a distribution from the inherited IRA within the 60-day time limit as long as the distribution is not a required distribution, the Internal Revenue Service (IRS) says.

When someone other than the spouse inherits an IRA, the rules become more complex. The account must be treated as a beneficiary IRA, and the heir cannot make contributions to the account or roll over any amounts into or out of the inherited IRA. The beneficiary must begin taking required minimum distributions regardless of age, but may extend them over the beneficiary’s lifetime.

The beneficiary may move the IRA into another IRA account however, if it is set up as a trustee-to-trustee transfer maintained in the name of the deceased IRA owner for the benefit of the beneficiary.

Inheriting a Workplace Account
Inheriting a 401(k) or other workplace account can be more troublesome for both the spouse and the non-spouse beneficiary, because the heir must withdraw the money according to the employer’s rules, the IRS says. Most employers do not want to maintain long-term relationships with the heirs of employees, SFGate.com says and require that the money be withdrawn either in a lump sum or over a period of five years.

Spouses can roll over at 401(k) into an IRA, but until Congress included a provision in the recently enacted Pension Protection Act that allows non-spouse beneficiaries to roll over an inherited workplace account directly into an inherited IRA, workplace accounts left to non-spouse beneficiaries were taxed as ordinary income.

When the IRS in January clarified their guidance on the new rules that will apply to a rollover of a workplace account by a non-spouse beneficiary, some financial advisors were surprised, SFGate.com says. The law does not apply retroactively, the IRS said, and only applies when the employer’s plan allows the transfer to a beneficiary IRA.

The transfer must be a trustee-to-trustee transfer, and the beneficiary should never take possession of the money, says IRA expert Ed Slott, according to SFGate. In addition, To qualify for the rollover, the non-spouse beneficiary must take the following steps when making the transfer:

  • Segregate the money in an inherited IRA. Do not mix with other IRAs.
  • Properly title the account.
  • Complete the rollover and take the required distribution no later than December 31 of the year following the death.

Holly Nicholson, CFP, writing for the Raleigh News and Observer, recommends that people who are changing jobs and who may have multiple 401k plans, establish a rollover IRA with a mutual fund family and transfer previous 401k plans into this IRA rather than roll over into a new company plan. This allows the IRA owner to name multiple primary and contingent beneficiaries, children or siblings, for example, and know that they can maximize their inheritance by taking minimum distributions.

The new law probably won’t affect the “fairly large percentage” of people who want to cash in inherited IRAs and workplace accounts says Michael Kitces, director of financial planning for Pinnacle Advisory Group, according to SFGate. “For most people who were going to spend it, they will probably spend it,” he says. For people who want to keep saving, [the new law] provides a much more tax-favored way to do it.”

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