Most 401(k)s and other employer-sponsored retirement plans are bequeathed to spouses, and with good reason. Until a recent change in rules, only a spouse could inherit a retirement plan other than an IRA and avoid immediate taxes. Now, although the process must be handled carefully, any beneficiary should be able to receive a retirement plan and enjoy the same tax-postponing benefits that a husband or wife always could.
 Under the old rules, if your spouse got the money, it could be rolled over into his or her own IRA and lifetime withdrawals would be permitted. Though each year’s required distribution would add to your spouse’s taxable income, the rest of the account would continue to compound, and there might be a sizable balance left at your spouse’s death.
But what about your daughter? Most employer plans require an account to be emptied within five years of an employee’s death. She would have had to take the money and, under the old rules of not being allowed to move it into an IRA, would have been stuck paying income tax immediately, which likely would have diminished her inheritance by a third or more.
The new rules are much kinder to non-spouse beneficiaries. Now, any beneficiary that you name may roll over the inherited plan to an IRA. But the law is prickly about the process. To make a successful rollover, your heir must do the following:
- Open an inherited IRA to take the money. A spouse who inherits a 401(k) can merge the account with her own IRA, but others must set up a new account specifically created to receive funds transferred from the deceased’s retirement plan.
- Be sure to title the new account correctly. For instance, “Dad IRA (Deceased) FBO Daughter.”
- Make sure the money goes directly from the company plan to the heir’s new IRA. If your beneficiary touches the money, he or she will be immediately taxed.
If you’ve ever changed jobs, you may already have transferred retirement funds from your former employer to an IRA. Until the rules changed, that was the only way to ensure favorable tax treatment for a non-spousal heir. And even now, a rollover to an IRA of your own is often advisable. IRAs tend to offer a wider range of investment options than you get in a typical 401(k), and it’s easier to monitor investments in a single account. Moreover, you may feel a lot more comfortable having the funds deposited in your own IRA rather than an account being administered by a former employer.
There is at least one advantage to keeping money in a 401(k), however. If you retire, you may begin taking distributions from an employer plan at age 55 without incurring the 10% early withdrawal penalty you would owe for withdrawing assets from an IRA before age 59½. Under the new rules, you can have the penalty-free early access of a 401(k) while also accommodating non-spousal heirs. |