Inheriting A 401(k)

The Pension Protection Act gives 401(k) beneficiaries reprieve from tax burden.


Among the 900-pages of the Pension Protection Act of 2006 lies good news for non spousal beneficiaries of 401(k) plans. The act grants such beneficiaries the ability to roll 401(k) funds they’ve inherited directly into a new inherited IRA established specifically to receive the 401(k) funds.

Spouses have always had this option, including the ability to roll the 401k balance into their own IRA. Non spouse beneficiaries, had to receive the 401(k) funds in whatever manner the plan documents prescribed – usually a lump sum distribution, creating an immediate state and federal tax burden and potentially pushing the beneficiary into a higher income tax bracket.

Beginning in 2007, nonspouse beneficiaries can move the funds to an IRA according to the rules:

1. The transfer must be directly from the 401k to the IRA. If the beneficiary receives a check, taxes kick in, even if the beneficiary deposits the check into the IRA.

2. The IRA must be an inherited IRA in the original 401(k) participant’s name, with the recipient as beneficiary – in other words, the IRA must be titled exactly like the 401(k) account. The 401(k) funds cannot be transferred to the beneficiary’s existing IRA.

3. The beneficiary must be a person or group of people, which can include a trust for the benefit of the beneficiary. The 401(k) funds cannot be transferred to the participant’s estate.

4. The beneficiary must take required minimum distribution (RMD) over his or her life expectancy. Those distributions are taxed as they are taken.

Beneficiaries got another boon with the expansion of rules for 401(k) hardship withdrawals. Existing law allows hardship withdrawals only for the participant,the spouse and legal dependents. The new rules allow participants to withdraw hardship funds for any person listed as a beneficiary of the 401(k).

The above changes also apply to 403(b) plans, typically available to teachers, and 457 retirement savings accounts for government employees.

If you inherit a nonspouse 401(k) account before the end of 2006, ask the employer to hold the distribution until Jan. 1, 2007. The trigger date is the date of the distribution, not the date of the participant’s death. And take extra care to ensure the plan administrator transfers the funds directly to your inherited IRA established to receive them. An error resulting in a check made payable to you will trigger a tax bill in  direct proportion to the size of the account.

An IRA typically will offer more choices than a 401(k) plan. Your financial professional can guide you in selecting investment options for the IRA and help you avoid any missteps in receiving and transferring your 401(K) inheritance.