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Have you recently inherited a 401(k)?
Many beneficiaries assume that there isn't
much to do but close the account and spend or invest the money. But, if you do so without
carefully investigating your options, you might be making a very costly mistake.
Why? Because the tax rules that govern an
inherited 401(k) are complex and confusing. In certain situations, action is required on
your part; in others, no action is required. If you were married to the participant, you
may have more options than if you were not the spouse. The only rule of thumb is that
ignorance of the rules can lead to costly missteps.
We can't make you a tax expert but we can try to alert you
to some common errors that beneficiaries make. This list isn't exhaustive, so before you
take action, we encourage you to get guidance and help from a CPA or attorney familiar
with 401(k) inheritance rules.
1. Neglecting to Report Your Withdrawals
to the Tax Authorities
Once you inherit a 401(k), any money that you receive from
it is reported to the federal (and possibly state) government by the 401(k) trustee under
your Social Security number. The deceased participant's name and Social Security number
are no longer used for tax reporting.
When you file your income taxes, you are responsible for
reporting the withdrawal and paying taxes on any portion that is taxable. Although 401(k)
distributions are usually taxable, it's possible that the employer allowed the participant
to make nondeductible contributions to the 401(k). Nondeductible contributions are not
subject to income tax when withdrawn. To learn whether nondeductible contributions may
have been made to a 401(k), look carefully at the account statement. If you don't
understand what it says, talk to a benefits administrator who can explain the details. The
401(k) trustee will report distributions to the IRS on Form 1099R, which identifies the
taxable and nontaxable amounts.
2. Closing the Inherited 401(k)
Immediately
Although 401(k) plan terms vary, you generally are not
required to close your inherited 401(k) immediately. You can usually keep the account open
and allow it to grow tax-deferred for many years. This is true whether you are the
participant's spouse or child, or someone completely unrelated. If the plan does require
that all the money be withdrawn, a spouse beneficiary may roll the distribution over to an
IRA but other beneficiaries may not.
By closing the account immediately, you will receive the
entire amount during a single tax year. Your distribution will be subject to federal (and
possibly state) income taxes. If the amount is significant, the windfall may push you up
to a higher tax bracket.
When distributions must start: 401(k) plans differ
in their distribution requirements; the following explanation assumes that the plan
permits as much flexibility as is allowed by law.
If required minimum distributions to the participant had
already begun before death, they must continue at least as rapidly after the participant's
death as before. If required distributions hadn't begun, the following rules apply:
A spouse beneficiary has the flexibility to delay
taking required distributions from a 401(k) until the year the deceased participant would
have reached age 70ý. The spouse beneficiary may also roll the account over to an IRA.
A nonspouse beneficiary must start taking required
distributions from the 401(k) by the end of the year following the year in which the
participant died. The required amounts are calculated so that they are approximately equal
over the beneficiary's life expectancy, determined using special IRS tables. If
distributions do not begin within this period, the nonspouse beneficiary must close the
account within five years from the end of the year in which the participant died.
Taxation: Apart from rollovers to an IRA, all money
distributed from a 401(k) is taxable except amounts that represent the return of
nondeductible contributions, determined under IRS rules.
Nondeductible contributions: Some plans allow
employees to contribute money on which they have already paid income tax and defer taxes
on investment earnings. Investment earnings withdrawn from the plan are subject to federal
(and possibly state) income tax. You can learn if there are after-tax contributions to the
plan by reviewing your account statement.
Generally, IRS rules treat nondeductible contributions as
being paid out as a pro rata portion of any distribution — you cannot take out
only the nondeductible contributions. (Some plans that went into effect in 1986 or earlier
are governed by a different rule allowing nondeductible contributions to be paid out
faster.)
Special tax rules: If the participant was born
before Jan. 1, 1936 and you take out the whole balance of his or her 401(k) in one year,
you may be eligible to have the distribution taxed under a special method known as
"10-year averaging." This might be an advantageous treatment — consult with
a tax advisor to determine if you qualify.
3. Ignoring the Inherited 401(k) until
You Really Need the Money
If you don't need the money right away, it may make sense
to keep the account open as long as possible. As long as the money stays invested in the
401(k), your funds can continue to grow tax-deferred. Further, you may have the option of
actively investing the account. If you trade within the 401(k), there is generally no
income tax liability on appreciated securities that you sell and no tax reporting that you
need to worry about.
However, the tax rules make it unwise for you to simply
ignore your account until you really need the money. If you delay taking distributions
from your account beyond certain deadlines, you face substantial tax penalties.
The rules are different for spouse and nonspouse
beneficiaries:
Spouse beneficiary: As the spouse of the
participant, you have a great deal of flexibility. The rules are generally structured to
let you keep the money in your 401(k) for many years.
Generally, you can keep the account open. If your spouse
was over age 70ý and already taking required minimum distributions at the time of death,
the general rule is that the minimum payout must continue at least as rapidly after his or
her death as before. (See No. 7 below for a possible exception in this
situation.) If your spouse hadn't started withdrawing required distributions, you can
defer withdrawing any money from the account until the year your deceased spouse would
have reached 70ý.
As a spouse beneficiary, you have the choice of keeping the
account as a "beneficiary account" in the 401(k) or doing a rollover to your own
IRA. If the account is maintained as a beneficiary 401(k) in the name of the original
participant, you can take withdrawals without owing a penalty if you are under age 59ý.
If you roll over the account to an IRA in your name, you will be subject to early
withdrawal penalties until you reach 59ý.
Nonspouse beneficiary: If you are anyone other than
the spouse of the participant, the tax rules give you fewer alternatives than a spouse
beneficiary. Fortunately, you do have some flexibility to spread the withdrawals over an
extended period.
If the participant already began required minimum
distributions before he or she died, you must continue to receive payments at the same
rate or faster.
If required distributions from the account haven't yet
begun, you can generally keep the account open for a long period. To do so, you must start
taking minimum withdrawals based upon your life expectancy by the end of the year
following the death of the participant. Once you begin, you may keep the account open
until all the money is withdrawn (unless the 401(k) plan terminates first). If you do not
start minimum withdrawals within this period, you are required to close the account within
five years from the end of the year that the participant died. If the account is not
closed within this period, you may face substantial tax penalties.
It makes sense to get guidance and help from an accountant
or attorney who specializes in these matters.
4. Expecting to Pay an Early Withdrawal
Penalty on Any Money That You Withdraw If You Are Under 59ý
Even if you are younger than 59ý when you inherit a
401(k), money that you withdraw from the inherited account will not be subject to the 10
percent early distribution penalty tax. If you are the spouse of the participant, you have
the option of rolling the account over to an IRA in your own name. If you choose to do so,
once the money is in the IRA, the early withdrawal penalty will apply to you.
5. Thinking That You Must Close the
Account Immediately If a Trust Was the Named Beneficiary
For estate planning reasons, a 401(k) participant will
sometimes designate a trust and not an individual as the beneficiary. Often it is assumed
without detailed analysis that because the beneficiary was a trust, the money must be
withdrawn immediately.
However, each trust document is different. In certain
situations, you may be able to treat the inherited account as though you were the named
beneficiary. In other situations, you may have no choice but to close the account
immediately. Before you act, you should have a professional specializing in this area
review the trust document and help you understand your options.
6. Assuming That You Can’t Roll the
Inherited Account to an IRA
A spouse beneficiary generally has the option of rolling
the account over to an IRA. A nonspouse beneficiary doesn't have this option.
Additionally, it may make sense for a spouse beneficiary not to roll over to an IRA
(see No. 3 above).
7. If You Are the Spouse of the Deceased
Account Owner, Thinking That You Are Required to Continue Required Minimum Distributions
If you're a spouse beneficiary who has not yet reached age
70ý, you can roll over the account into your own IRA, even if the participant already
started required minimum distributions. The effect of the rollover is to stop the required
minimum distributions. You won't be required to start distributions from your IRA until
the calendar year after you reach 70ý. |
