One of the most powerful estate planning vehicles today is actually hiding in your clients’ IRAs. Though the inherited — or “stretch” — IRA can allow your clients’ beneficiaries to stretch the tax-deferral benefits associated with these accounts for years after the original owner’s death, the equation becomes more complicated when your client holds retirement funds in a qualified plan, such as a 401(k) or profit sharing plan. These clients don’t have to miss out on the opportunity to stretch the tax benefits of these retirement plan dollars into the next generation, but careful planning is necessary to ensure that your clients don’t end up taking a tax hit instead.
Inherited Retirement Accounts: IRA vs. 401(k)
Most clients know that the rules governing inherited IRAs generally allow your clients to “stretch” the tax-deferral associated with these accounts by providing for distribution of the account value over a period of years following the original account owner’s death. Typically, the account beneficiary will take distributions over his or her lifetime or exhaust the account funds within five years of the original owner’s death, which allows the account value to continue to grow and stretches the tax liability that accompanies the distributions over a period of years.
What clients may not know, however, is that qualified plans (such as 401(k)s and profit sharing plans) are subject to a different set of rules that do not allow the funds to be distributed over time. As a result, when your client’s 401(k) is inherited, the funds will usually be distributed immediately in a single lump sum payment, resulting in an immediate tax liability for the beneficiary.
If the designated beneficiary of an inherited 401(k) is an individual, however, the client has the option of rolling the inherited account funds into an IRA that will be treated as an inherited IRA, thus allowing the client to gain the ability to stretch distributions over his or her life expectancy (or over a five-year period). The rollover must be accomplished through a trustee-to-trustee transfer whereby the 401(k) plan administrator transfers the funds directly into a new IRA account that only holds the inherited 401(k) funds.
Planning for the inherited IRA
In the inherited retirement account arena, ensuring that your client’s beneficiary designations are updated is key to a successful transfer of the account to the next generation. Important to note, the account’s beneficiary designation trumps even the client’s will in determining who will inherit the account.
If your client has failed to name a beneficiary, the IRA will likely be paid out to his or her estate upon death — which will cause a loss of the tax-deferral benefits that can otherwise be realized with an inherited IRA. This is because the favorable rules that allow the account value to be distributed over time only apply if the account’s designated beneficiary is an individual (or a trust, the beneficiary of which is an individual) that actually has a life expectancy.
Further, if the estate is the eventual beneficiary of an inherited qualified plan (401(k)), the client loses the option of rolling the funds into an inherited IRA in order to maximize the tax-deferral potential.
While most clients cannot control the type of retirement accounts that they have inherited, when it comes to maximizing the tax-deferral benefits associated with inherited accounts, knowing the rules of the game is key to avoiding a major tax hit when these accounts change hands.
For previous coverage of the use of inherited IRAs in Advisor’s Journal, see The Stretch IRA’s Ouster from the Estate Planning Arena—What Clients Need to Know Now.
For in-depth analysis of retirement accounts in the estate planning context, see Advisor’s Main Library:L—Coordinating Retirement Accounts with Estate Planning.
Your questions and comments are always welcome. Please contact the Panel of Experts.