Your options in managing assets that you inherit from a loved one’s qualified retirement plan may depend on the type of retirement plan in question (401(k), 403(b) plan or IRA) and your relationship to the deceased. It’s important to know the rules involved so that you can manage those assets in the most tax efficient manner as possible.
Employer-Sponsored Retirement Plans
Federal laws require that a spouse be the primary beneficiary unless he or she waives that right in writing. When retirement plan assets are left intact within an estate, spousal beneficiaries may inherit the money without paying federal estate or income taxes. After age 70 1/2, the surviving spouse must begin required minimum distributions (RMDs) based on his or her life expectancy. The RMDs are taxed as ordinary income.
Note that recent legislation permitting retirement investors to forego RMDs for 2009 also applies to beneficiaries who otherwise would be required to take RMDs this year. According to current rules, RMDs will once again be required during 2010.
With nonspousal beneficiaries, the plan’s rules may determine the beneficiary’s options. Some plans require nonspousal beneficiaries to cash out retirement plan bequests between one and five years after the account owner’s death. In contrast, other employer plans may offer nonspousal beneficiaries the option of completing a trustee-to-trustee transfer from an employer-sponsored plan to an IRA established for this purpose and subsequently taking annual distributions based on the beneficiary’s life expectancy. Regardless of the method that you follow, distributions taken by heirs are taxed as ordinary income.
It is critical that beneficiaries determine the rules of the deceased’s retirement plan and consult a financial advisor who can make sure that a bequest from an employer-sponsored retirement plan is managed properly, thereby avoiding unnecessary tax payments.
Inheriting IRAs
With an IRA, spousal beneficiaries may designate themselves as the account owner and treat an inherited IRA as their own. This means a surviving spouse can transfer the assets to an existing IRA or to an employer-sponsored plan. These transfers typically do not trigger tax payments as long as a spouse follows the rules for trustee-to-trustee transfers. After age 70 1/2, a spousal beneficiary is mandated to take annual RMDs, which are based on the surviving spouse’s life expectancy and are taxed as ordinary income.
Nonspousal beneficiaries cannot transfer assets within an inherited IRA to an existing IRA. Instead, they have two options:
- They may take all distributions within five years of the original account owner’s death or
- Take annual distributions determined by the life expectancy of either the beneficiary or the decedent, whichever is longer.
Because determining the tax status of inherited assets can be complicated, you may want to consult an estate-planning attorney or a financial advisor to answer any questions you may have.
This was prepared by S&P 500 publications. Securities offered through LPL Financial, Member FINRA/SIPC.
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To the point regarding non-spouse inheriting of the 401(k) assets – As the living owner of such an account, it would be kind of you to check what distribution options the administrator offers. What a shame if your child is forced to take a 5 yr payout, potentially paying far higher taxes than they otherwise would have to had you rolled that 401(k) into an IRA and left proper instructions.
Consider, 401(k)s can easily contain $1M. A 50yr old beneficiary forced to take a 5 yr payout has to withdraw $200K/yr, easily sending him/her into the highest tax brackets. That same 50 yr old starts Beneficiary RMDs at a 1/34.2th withdrawal rate (that’s 2.92%) or $29,200 first year withdrawal.
This point cannot be over emphasized. One decision can save your heirs a huge amount in taxes, not to mention, if they stick to only their RMDs, will provide a nice income for life, vs a 5 yr windfall. The psychological difference in how the money is received is real.
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