By Jason Alderman
Talk about good news wrapped in bad: In the midst of grieving the loss of a loved one, you learn that you were named beneficiary of their 401(k) plan. Chances are you’ve got too much on your mind to make any sudden decisions about what to do with the money.
However, don’t procrastinate too long. The IRS has ironclad rules, deadlines and penalties concerning inherited retirement accounts, which vary depending on what type of account it is. This column discusses inherited 401(k) and similar employer-provided plans.
Under federal law, surviving spouses automatically inherit their spouse’s 401(k) plan unless someone else was named beneficiary and the surviving spouse signed a written waiver. If someone is single at death, their plan’s assets go to their designated beneficiary.
The IRS has basic tax and distribution rules and timetables for inherited 401(k) plans. However, the plans themselves are allowed to set more restrictive guidelines if they choose, so read the plan documents carefully. Basically:
You must pay income tax on distributions (except for Roth accounts, which have already been taxed), although you may be able to spread out withdrawals and tax payments over a number of years, depending on how you structure it.
Many 401(k) plans require beneficiaries to withdraw the money in either a lump sum or separate payments extending no longer than five years after the person’s death; however, some will allow you to keep the money in the plan indefinitely, so check their rules.
Note that distributions will be added to your taxable income for the year, which can greatly increase your tax bite. Thus, many people prefer to spread the payments out as long as possible. Plus, the longer funds remain in the account, the longer they accrue earnings, tax-free.
If the original account holder had already reached the mandatory withdrawal age of 70 ½, you may be allowed to continue withdrawing funds according to his or her withdrawal schedule. Your minimum annual withdrawal amount is based on your own life expectancy, according to IRS tables (see Appendix C in IRS Publication 590 at www.irs.gov). Alternatively, you could speed up the payment schedule or take a lump sum.
You may also be able to transfer your balance into an “inherited IRA,” which must be named and maintained separately from your other IRAs. With an inherited IRA, you must withdraw a certain amount each year, based on your life expectancy. Distributions must begin the year following the donor’s death, regardless of whether or not you’re retired.
Make sure the 401(k) trustee transfers funds directly to the inherited IRA’s trustee so you never touch the money; otherwise the transfer may be voided and you’ll have to pay taxes on the entire sum that year.
Surviving spouses have an additional option: Instead of opening an inherited IRA, they’re also allowed to do a “spousal rollover,” which means rolling over the balance into an existing or new IRA in their own name. The key advantage of a spousal rollover is that you don’t have to begin taking mandatory withdrawals until you reach 70 ½, unlike inherited IRAs where you must begin withdrawals the year after the donor’s death.
One last point: Always withdraw at least the required minimum distribution (RMD) amount each year, if one is specified. If not, you’ll pay a penalty equal to 50 percent of the difference between the RMD and what you actually withdrew.
Bottom line: Talk to a financial or legal expert before taking any action on your inheritance.
Jason Alderman directs Visa’s financial education programs. To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney.