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 or IRA. Chances are you've got too much on your mind to make any sudden decisions about what to do with the money. That's a good thing -- better to research your options first.
However, don't procrastinate too long. It turns out the IRS has ironclad rules, deadlines and penalties concerning inherited retirement accounts. And, the rules vary depending on what type of account it is. This column will discuss inherited 401(k) and similar employer-provided plans such as 403(b) and 457 plans; we'll tackle inherited IRAs in a future column.
Here's how it works:
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. (Note: If you're divorced and want to ensure your ex won't receive your benefit, seek legal guidance.)
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 to ensure you fully understand your options. Basically:
You must pay income tax on the 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 a lump sum or in 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 you take 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 over as long a time period 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). Alternatively, you could speed up the payment schedule or take a lump sum.
Inherited IRA. You may also be able to transfer your balance into an inherited IRA (or "stretch IRA"), which must be named and maintained separately from your other IRAs. (For example, it might be called, "Inherited IRA for benefit of Mary Smith as beneficiary of John Smith.") 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) plan trustee transfers the 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. Also, if multiple beneficiaries were named, consider asking the plan custodian to split the account so each beneficiary can take distributions as he or she wishes.
Spousal rollover. Surviving spouses have another option other beneficiaries do not: In addition to 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 doing 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. Thus the balance can continue to grow tax-free for a longer period if you're well under retirement age.
However, note that if you're under 59 ½ and decide to withdraw from a spousal rollover IRA (that is, one that's in your name only), you'll not only have to pay income tax on the amount, but might also be face a 10 percent early withdrawal penalty. Inherited IRAs aren't subject to the penalty.
One last point: Always withdraw at least the required minimum distribution (RMD) amount each year, if one is specified. If not, the IRS will sock you with a penalty equal to 50 percent of the difference between what you should have taken out (the RMD) and what you actually withdrew.
Bottom line: Talk to a financial or legal expert before taking any action on your inheritance.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.