3692 / How could an IRA be used to stretch the tax benefits of funds held within an inherited 401(k) over a beneficiary’s lifetime prior to 2020?

Inherited IRAs generally allowed an individual 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.¹ See Q 3687 to Q 3689 for a discussion of the distribution rules that apply following the original account owner’s death.

Qualified plans (such as 401(k)s and profit-sharing plans), however, have always been subject to a different set of rules that do not allow the funds to be distributed over time. As a result, when a 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, prior to 2020, he or she had the option of rolling the inherited account funds into an IRA that would be treated as an inherited IRA, thus allowing the individual to stretch distributions over his or her life expectancy (or over a five-year period). The rollover had to 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.

If the original account owner 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.²

Further, if the estate is the beneficiary of an inherited qualified plan (401(k)), the taxpayer loses the option of rolling the funds into an inherited IRA in order to maximize the tax-deferral potential.