Inherited IRAs receive much attention for their ability to “stretch” the tax deferral benefits of an IRA over the lifetime of a beneficiary who may be much younger than the original account owner—potentially spreading the bulk of the tax liability over decades.
Planning opportunities can abound with the inherited IRA, but the basic rules governing the treatment of these accounts are relatively well-known. The rules governing inherited qualified plans (such as a 401(k) or 403(b) account) present a different set of complications that must be understood when a client inherits this type of account—and understanding the post-death tax treatment of qualified plans is critical to avoiding a major (and immediate) tax hit for your client.
Post-Death Qualified Plan Distributions
While inherited IRAs often may be distributed over time (spreading the associated tax liability over the beneficiary’s lifetime), 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 a client inherits a 401(k), the funds typically must be distributed immediately in a single lump sum payment, resulting in an immediate tax liability for the beneficiary. Most plans will specifically require lump sum distribution treatment because of the administrative burdens associated with allowing stretched out distributions.
Fortunately, certain beneficiaries have the ability to roll those funds into an inherited IRA. Once the funds are in the inherited IRA, they must be distributed according to the same rules that govern inherited IRAs (discussed below). While this option is now generally mandatory (under IRC Section 402; prior to 2010, a plan only had the option of allowing an inherited 401(k)-to-inherited IRA rollover), not all beneficiaries are eligible to roll inherited 401(k) funds into an inherited IRA.
Only a designated beneficiary is entitled to take advantage of the option of rolling the inherited 401(k) funds into an inherited IRA. A designated beneficiary for this purpose means an individual, or certain trusts that qualify as “see through” or “look through” trusts. This means that the trust is an irrevocable trust that is valid under state law and identifies the beneficiaries of the trust as individuals (the trustee also must provide a copy of the trust document).
Estates and other trusts that inherit a 401(k) are not designated beneficiaries for this purpose, so their distribution rights will be limited to those provided in the plan document itself.
The rollover must be accomplished in a trustee-to-trustee transfer (i.e., directly between the relevant financial institutions).
Inherited IRA Distribution Rules
Once the funds are rolled over into an inherited IRA, the distribution requirements depend upon whether the beneficiary is a spouse or non-spouse beneficiary. A spousal beneficiary has the option of rolling the funds into an inherited IRA or his or her own IRA.
The most attractive option for many surviving spouse beneficiaries is to simply roll the inherited IRA funds into an IRA that is treated as though it were the surviving spouse’s own IRA. If the surviving spouse is named as the sole beneficiary of the IRA and elects to treat the inherited IRA funds as though they were his or her own, the account will be treated as though the surviving spouse is the owner for all purposes—including required minimum distribution (RMD) calculations.
A non-spousal beneficiary cannot depend on waiting until age 70½ to begin taking RMDs—he or she must either withdraw all funds within five years or based upon his or her life expectancy. RMDs will depend on whether the original owner died before or after his or her required beginning date.
The rules governing inherited qualified plans can be much more complex than those governing inherited IRAs—making the advice of an informed financial advisor critical to getting it right for the client.
- Check out previous coverage of inherited IRAs in Advisor’s Journal.
- Please read more in-depth analysis of estate planning for retirement assets, in Advisor’s Main Library.
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