The ins and outs of inherited retirement plans

The rules dealing with inherited IRAs and other tax-advantaged retirement plans, such as 401(k)s, are among the most confusing provisions of federal tax law. But taking the time to become familiar with them is worthwhile. Remember, retirement plan withdrawals are generally subject to income tax. So if your estate includes substantial sums in such plans, understanding the tax implications for your beneficiaries can help you plan accordingly. (If you’re a beneficiary, you may be able to reduce the tax impact of your inheritance.)

Planning is particularly important if you’ve designated someone other than your spouse as the beneficiary of your 401(k) or similar retirement plan (or you’re the nonspouse beneficiary). The tax code now permits nonspouses to stretch plan distributions — and the resulting taxes — out over their own life expectancies through a “nonspousal rollover,” but not all plans offer this option.

Minimum distribution rules

One key to understanding the tax treatment of inherited IRAs is knowing how required minimum distributions work. Generally, as the original owner of a retirement plan, you must begin taking distributions by April 1 of the year following the year you reach age 701⁄2. In some cases, you can delay distributions from an employer-provided plan if you continue working.

Calculating required minimum distributions is complicated, but typically the amount you must withdraw each year is based on your life expectancy or on the joint life expectancies of you and your spouse or another designated beneficiary.

Having a designated beneficiary, especially one who’s younger than you, can reduce required distributions after your death, maximizing the benefits of tax deferral. If you don’t choose a beneficiary or if you designate your estate as the beneficiary, distributions — and the taxes on them — will be accelerated.

Postdeath distributions

The rules on postdeath distributions are complex. But generally your beneficiary must begin taking distributions over his or her life expectancy. If the beneficiary is your spouse and is younger than 701⁄2, however, there’s another option: Your spouse can move the assets into an IRA in his or her own name and delay distributions until he or she reaches age 701⁄2.

401(k) and similar plans work a little differently than IRAs. Although the tax code permits a beneficiary to stretch out required minimum distributions over his or her life expectancy, many plans — for purposes of administrative convenience — require the beneficiary of a deceased participant to withdraw the benefits in a lump sum or within five years.

A surviving spouse can defer the tax by rolling the funds into an IRA in his or her own name. But until recently, a beneficiary other than your spouse didn’t have that option. Unless the plan permitted distributions over the beneficiary’s life expectancy, a nonspouse beneficiary had to withdraw the funds in a lump sum or over five years, which would mean larger current tax liability, perhaps pushing the beneficiary into a higher tax bracket.

Fortunately, the Pension Protection Act of 2006 changed the law to allow nonspousal beneficiaries to transfer assets from a qualified plan into an “inherited IRA.” But nonspousal rollovers go into an IRA in the name of the deceased participant, not in the beneficiary’s own name. And the beneficiary can’t defer distributions until age 701⁄2. Rather, the beneficiary must take required minimum distributions over his or her life expectancy, beginning no later than the end of the year following the year the participant dies. To qualify, the funds must be moved directly to the IRA through a trustee-to-trustee transfer by the end of the year following the year the qualified plan participant dies.

Despite this welcome change in the law, qualified plans aren’t required to allow nonspousal rollovers. Even for plans that allow them, the deadlines are tight. A full year after the year the participant dies may seem like a long time, but administering an estate can be a lengthy process, and it’s not unusual for a year or more to pass before qualified plan assets are transferred.

Plan now

If you have a sizable 401(k) or similar plan and have named a beneficiary other than your spouse, check to see whether the plan allows nonspousal rollovers. If it does, be sure that your heirs are aware of IRS deadlines. If it doesn’t, consider rolling the funds into an IRA during your lifetime.

Even if your plan allows nonspousal rollovers, you still might want to transfer the funds to an IRA to avoid any risk that your heirs will miss the deadline and be forced to take distributions on an accelerated schedule. Whichever strategy you adopt, be sure to prepare valid beneficiary designations and store them in a safe place that’s accessible to your heirs. •