401k Distribution Rules
Hello,
We got a new client back in 2022. His dad had recently passed away. Dad owned a 401k held at Prudential. Dad did not have anyone listed as a beneficiary. My client “Michael” is the only child of dad.
Thus, he inherited the 401k by reason of being the closest relative. Prudential stated that since there was not a beneficiary listed that it could not be rolled over into a decedent IRA. Prudential informed him that he is subject to the 5 year rule by which he would have to remove all of the money within 5 years and pay tax on it.
The client decided to just remove the entire amount at one time. We had Prudential withhold 25%.
He uses H & R Block to file his taxes.
The IRS claims that since the account was (1) a 401k that it is “income is respect of a decedent”. Thus, the IRS claims that the income needs to be reported on Form 1041 instead of Form 1040.
The gross amount of the distribution was $227,156. The tax rate on the Form 1041 was at 36%. Thus, we under withheld by 11%.
I spoke to the person at H & R Block who prepared the returns. He said that if the money would have been in an IRA, then it would go on my client’s Form 1040, but since it came out of a 401k it is required to be reported on Form 1041, Income Tax Return for Estate and Trust.
Do you agree with the IRS’ position on this?
Thank you.
Permalink Submitted by Alan - IRA critic on Fri, 2024-12-20 16:21
The distribution must be reported on the return for the entity that received it. This was probably the estate EIN. But that does not mean that the estate must pay the taxes, as the distribution can be passed out of the estate on Form K 1 to the client, and client will owe taxes at his lower marginal tax rate.
HR Block was right about the reporting, but this is true whether it was paid from any type of plan for which the estate is the beneficiary.
I doubt that the 401k plan would have agreed to distribute over 5 years, as a total distribution to the estate is typical whether the executor wanted to or not.
By not naming the son as beneficiary on the 401k, father cost the son thousands of dollars in taxes because if he named the son as beneficiary, the son could spread the distributions out over 10 years.