Beneficiary IRA or not?

Submitted by Alan Myers on Thu, 2024-01-11 16:27

I have a mildly complicated question. I have a client whose daughter passed away from cancer. Daughter had a 401(k) at her job but failed to name a beneficiary. Daughter had three kids when she passed. Given that estates always go up first (i.e. to the parents) and then down (i.e. to the kids next) and then to anyone else, my client as Mom is the beneficiary of the 401(k). My client (Mom) wants the proceeds from the 401(k) to benefit the kids (her grandkids).

It would seem obvious that the first step is to set up a beneficiary IRA for Mom (my client) and roll the proceeds from 401(k) into that account – or am I wrong in that assumption? Once the money is in the beneficiary IRA, what is the best sort of account to set up for the kids (none are over the age of majority yet) to make transfer of assets from Mom to grandkids easiest? If I am thinking this through correctly, there is no way to transfer the money without paying taxes on the distributions so just setting up custodial accounts for each of the three kids seems most logical.

Am I missing anything here? Can anyone offer me any creative or viable alternatives?

Thanks!
Alan R. Myers, CFA



Submitted by David Mertz on Thu, 2024-01-11 17:04

  • If the default beneficiary is the estate, no rollover to an inherited IRA is permitted.  The only option is to make distributions to the estate which are not eligible for rollover.
  • The state intestate provisions almost certainly have children inheriting before parents.  With regard to the 401(k), the children will receive cash from the estate, not a retirement account.  The Income to the estate resulting from distributions from the 401(k) to the estate can be passed through on Schedules K-1 (Form 1041) to the children for inclusion on their tax returns.  With daughter having children but no will, Mom is not a beneficiary of the estate.
  • To avoid a large single taxable distribution to the estate, it might be possible to keep the estate open to receive partial yearly distributions from the 401(k) if the 401(k) plan permits.
  • As long as this was not a solo 401(k), if daughter was married at the time of her death, daughter’s spouse is the default beneficiary, not the estate.


Submitted by Alan Myers on Thu, 2024-01-11 17:38

Thanks for the corrections!  You are, of course, correct that estates go down and then up so the kids are first in line followed by Mom. When I called my custodian about setting up an estate account for this, they do actually have an “inherited IRA for an estate beneficiary” account option.  So the 401(k) would roll to an IRA with the estate as the owner of the IRA.  From there, it would be disbursed to the kids and I am now calling an estate attorney to figure out how to best handle this part of my questions.  Thanks again for all of the help!



Submitted by Alan - IRA critic on Thu, 2024-01-11 19:01

  • The custodian must be under the impression that an IRA was inherited rather than a 401k. Below is copied from IRS Reg 1.402(c)(2), QA 12:
  • “(b) Non-spousal distributee. A distributee other than the employee or the employee‘s surviving spouse (or a spouse or former spouse who is an alternate payee under a qualified domestic relations order) is not permitted to roll over distributions from a qualified plan. Therefore, those distributions do not constitute eligible rollover distributions under section 402(c)(4) and are not subject to the 20-percent income tax withholding under section 3405(c).”
  • Suggest that withholding (default rate is 10% for non rollover eligible distributions) be declined to avoid the situation where taxes are withheld for the estate EIN when the estate cannot pass any withholding through to the estate beneficiaries who will owe taxes on the distribution.


Submitted by Alan - IRA critic on Thu, 2024-01-11 17:18

  • I am assuming that daughter did not have a will, so these funds will pass under state intestate rules. In most states, if there is no spouse and no will, the biological children will inherit prior to a living parent. Suggest you check on this for your state.
  • Regardless of state intestacy law, the tax code does not allow a direct rollover to beneficiaries who are not designated beneficiaries or beneficiaries of a qualified trust. While the 5 year rule applies, almost all 401k plans will push out a lump sum distribution to the estate. Unlike an inherited IRA where the funds are already in an IRA and an executor can assign the inherited IRA out of the estate to separate inherited IRA accounts for estate beneficiaries, there is no way to do this with an inherited 401k, 403b, etc. 
  • When the lump sum is received by the estate, the executor can determine how much of that to pass through to the intestate estate beneficiaries via a K 1. That would allow these beneficiaries to report the taxable income on their 1040 and pay tax at their lower personal tax rates or under kiddie tax rules.
  • The executor should consult with a trust and estate attorney to determine if there is any advantage for the estate to elect a fiscal year term instead of a calendar year. 
  • It’s too bad the daughter did not name the kids as beneficiaries, despite being minors. They would have been eligible designated beneficiaries, could have done a direct rollover to inherited IRAs, and taken life expectancy RMDs until age 21, after which the 10 year rule would have kicked in. 


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