Tax Article - 401(k) Heirs: Act Fast

Recently, Congress implemented a new law that allows anyone who inherits a 401(k) to receive the same favorable tax treatment that had previously been reserved for spouses. It gives the taxpayer the option of withdrawing the inherited money over their expected lifetime in order to minimize the up-front tax due. Until this time, spouses have been free to transfer inherited 401(k)s to individual retirement accounts enabling them to spread out the withdrawals without penalty, while non spouse beneficiaries typically have been required to withdraw all funds from the account and pay taxes within a matter of months. Such an inheritance has also forced some survivors into a higher tax bracket, further increasing their tax burden.

The new law allows non spousal heirs to roll a deceased person’s workplace retirement fund into a special IRA, known as an inherited IRA. The beneficiary must make annual withdrawals from the inherited IRA but is allowed to spread these out over his or her lifetime. The change applies to all workplace retirement accounts, including 403(b) plans for teachers and other nonprofit workers, corporate profit sharing plans, and 457 retirement plans for government workers. It is also worth mentioning that the new enactment helps heirs qualify for a special break in the tax law that affects people who have employer stock in their 401(k). It allows the heir of an undistributed retirement account to split the account into two, one portion consisting of employer stock which would be placed in a taxable account. The other portion would be rolled over into an IRA. The stock portion that was distributed would only be taxable to the extent of the actual cost of the stock. Some experts believe that the new rule could ultimately save many heirs tens of thousands of dollars each in taxes.

Unfortunately, in order to personally benefit from this new ruling, the plan itself must be willing to offer the new benefit. The enactment allows employers the option of amending their 401(k) plan to make IRA transfers more widely available. The reality of the new law is in serious question because many employers do not expect to amend their current plans due in large part to the fact that making changes would obviously cost the company money in many ways. Paperwork revisions and training to inform employees of the changes are just a few of the related costs that employers would be forced to incur.

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Even heirs of actual amended 401(k) plans may not benefit from the new law if proper action is not taken in a timely fashion. Non spouse beneficiaries have until a specific date to transfer all inheritances to an IRA, normally the last day of the year after the former account owner’s year of death. If the deadline is missed, heirs can still move the money into an IRA, but will not be given the opportunity to span the income tax payments over their life expectancies. In turn, they will be forced to act in accordance with the plan’s rules regarding the timetable of inherited withdrawals, most requiring that the entire account be withdrawn and the taxes paid within five years.

In order to avoid subjecting your heirs to future employer’s rules, it is strongly recommended to transfer your 401(k) to an IRA account before retiring or moving on to new employment. A large number of businesses also allow current employees to transfer money out of the plan while they are still actually on company payroll. Inherited or not, retirement plans are many individuals’ biggest liquid asset. Any false moves could ultimately cost thousands of dollars in taxes.

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