The rules governing inherited individual retirement accounts and 401(k)s have become increasingly complicated in post-Secure Act years.
In particular, non-spouse beneficiaries who inherit retirement accounts must deal with a host of new complications — and related tax issues — when evaluating their required minimum distribution obligations after the death of the original account owner. And while RMD planning receives a significant amount of attention in determining the best way to minimize overall tax liability, beneficiaries often overlook one simple step that can inadvertently cause the entire inherited account balance to become currently taxable.
The inherited account must be moved to a beneficiary account unless the beneficiary was the original owner’s spouse — and if the wrong method is used for moving the account balance, all of those tax minimization opportunities can be lost.
It’s important, then, to have a trusted advisor review the details of any proposed transaction to prevent expensive mistakes.
Moving the Account Balance
Inherited IRAs and 401(k)s are different types of accounts when compared with their original predecessor accounts. Typically, when you own an IRA or 401(k), you’re entitled to consolidate those accounts by rolling over the funds in one account into another without tax liability. Of course, while only one IRA-to-IRA rollover is permitted in any 12-month period, the rule does not apply to direct transfers.
Non-spouse beneficiaries are not entitled to roll inherited funds into their own IRAs and 401(k)s. They must instead establish a separate beneficiary account that includes both the beneficiary’s name and the original account owner’s name.
How the funds are transferred from the original account to the beneficiary account matters. The key thing to remember is that the funds cannot be paid directly to the beneficiary even if the beneficiary intends to deposit the funds into a beneficiary account.
For IRAs, the transfer should be accomplished via a direct trustee-to-trustee transfer. The existing IRA custodian will cut a check that makes the account balance payable to the new beneficiary IRA, and this transaction is not reportable to the Internal Revenue Service. Any beneficiary can use this direct transfer method, including trusts and estates, which are considered non-person beneficiaries.
For qualified plans, the transfer should be accomplished via a direct rollover from the 401(k) or 403(b) plan into a beneficiary IRA. That means that the existing plan sponsor transfers the funds directly to the newly established beneficiary IRA. This method, however, is not available to trusts and estates, as non-person beneficiaries.
A non-spouse beneficiary who is not an eligible designated beneficiary may be permitted to allow the funds to grow tax-deferred for up to 10 years. Annual RMDs are required if the original account owner died after their required beginning date — but the beneficiary can still spread the associated tax liability over 10 years and realize significant tax-deferred growth.
Transferring the funds in an improper manner can lead to the entire account balance being treated as a distribution, making it taxable in the year of distribution.
Potential Pitfalls
Any RMDs that are currently due from an inherited 401(k) must be taken before the funds can be transferred into the beneficiary account. That makes it important to check with the plan administrator before executing the transfer.
Beneficiaries of Roth IRAs should also be concerned with the method of distribution to the inherited Roth IRA. Non-eligible designated beneficiaries of Roth accounts are also subject to a 10-year withdrawal period, although they are not required to take annual RMDs. It can potentially be valuable to allow the funds to grow over the entire 10 years, because Roth distributions are not taxable. This includes earnings in most cases.
Using the wrong transfer method can cause the beneficiary to miss out on maximizing the tax-free benefit of the inherited Roth account.
It’s also important to use the right type of beneficiary account. A traditional 401(k), for example, should be transferred into a traditional inherited IRA. If the traditional account is transferred into a Roth inherited account, the pretax dollars are included in the beneficiary’s income during the year of transfer. That is similar to the tax treatment of a typical Roth conversion.
© Touchpoint Markets, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.