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.