Plan sponsors often educate plan participants about the importance of beneficiary designations. It is equally important to help participants understand the rules that may apply to 401(k) plan assets that are inherited.
Plan participants may be beneficiaries of parents’ or spouses’ accounts, or they simply may want to prepare their beneficiaries for the future. Either way, it’s helpful to offer basic information on inheriting qualified plan assets, so families understand the issues and have the time to make well-considered decisions.
While the Internal Revenue Service (IRS) has established specific rules for the treatment of inherited retirement plan assets, employer-sponsored plans may set even stricter limits, so it’s critical for account owners and beneficiaries to understand the framework within which decisions will be made. Beneficiaries have many options when they inherit 401(k) assets, though some only apply to spouses of the deceased plan participant. Options include:
- Beneficiaries may keep assets in the plan; a spouse may also rollover assets to the spouse’s employer-sponsored plan. These options depend on the specific provisions of the plan(s). Plans may also have a default option if the beneficiary does not act within a stated period. See also #4 below.
- Spouses may Transfer assets to their own IRA. The Spouse’s IRA can either be pre-existing or opened to receive the funds from the plan. Regular IRA rules generally apply, and distributions are not subject to the rules discussed in No. 4 below.
- Transfer assets to an inherited IRA. Beneficiaries, including spouses, may transfer funds from most plans to a particular type of IRA termed an inherited IRA. For non-spouse beneficiaries, the transfer must be a direct rollover to the inherited IRA. Unlike other IRAs, assets in inherited IRAs must be distributed according to specific requirements. Also see No. 4 below.
- Distributions of assets left in the plan or transferred to an inherited IRA. The rules and options differ depending on whether the deceased plan participant died before or after being subject to required minimum distributions (April 1 following the year the participant turned 70 ½ is the “RMD Date”). If the person died before the RMD Date, the beneficiary must take a distribution either within five years or in a series of single life expectancy payments. If the person died on or after the RMD Date, single life expectancy payments are the only option. In either case, the calculations for the single life expectancy payments are different for spouses. Distributions received by beneficiaries not yet 59 ½ are not subject to any penalty for early withdrawal. Plans can impose more stringent time requirements for withdrawals from the plan.
- Take a lump sum distribution. Lump sum distributions have the potential to be the most costly option for beneficiaries. While it can be awfully tempting for a beneficiary to move an inheritance to a non-retirement account for easy access, the tax consequences of such a decision can be enormous. It’s likely the entire inheritance will be subject to immediate taxation.
- Opt not to accept the inheritance. By filing a “qualified disclaimer” (normally before September 30th of the year following the year of death), the assets can be disclaimed and given to an alternate beneficiary, avoiding any tax issues that would have arisen from the inheritance.
The above provides the basic options for beneficiaries of plan assets. However, the IRS rules are complicated and in any situation there can be additional details and requirements to be considered. This is a helpful topic for retirement education programs to embrace because uninformed beneficiaries can make expensive tax mistakes.
Before retirement, Terry Dunne was the senior vice president and managing director of Retirement Services at Millennium Trust Company, LLC. Mr. Dunne has over 40 years of consulting experience in the financial services industry. He has written extensively on retirement planning, industry trends, technology, and legislation. Millennium Trust performs the duties of a directed custodian, and as such does not sell investments or provide investment, legal or tax advice.
