401k non spouse beneficiary options
I have a client that is widowed. Has current money still in his old company 401k plan. Has named his adult children as beneficiaries. My concern was since his money is NOT in an IRA, that at his death the children will have to pay the taxes on the IRA. His other advisor told him that the kids can roll the 401K money over to their own IRA’s and not have to pay taxes. I think that is incorrect. I think once the money goes from the 401k to the kids IRA’s, all the taxes are due. I did hear that the IRs has a new rule that will allow for what is termed a “direct trustee to trustee transfer”, so in essance if the plan allows for this clause, (I am not even sure if I have worded that correctly), that the kids CAN roll the 401k to an inherited IRA and do a stretch, there is some type of new non-spouse beneficiary ruling by the IRS. Problem is from what I have heard, that plan sponsor must be will to do the above type of transfer, and it seems that most of the plan sponsors do NOT allow for this. Can someone please help me with this, is this some type of “loop hole” that looks like it makes sense, but in reality most plan sponsors do not allow for this. Thank you.
Permalink Submitted by Bruce Steiner on Thu, 2008-08-21 20:08
It doesn’t matter whether most plans allow it. The issue is whether this particular plan allows it.
Permalink Submitted by Alan Spross on Thu, 2008-08-21 20:09
The direct transfer option to a non spouse inherited IRA first became available in 2007, and the IRS issued a clarifying ruling last year in Notice 2007-7. See link below and go to Sec 829.
Although offering the transfer is optional at this point, it may well become mandatory and in addition more and more plans are offering the transfer as time passes. It would be wise to inquire whether his plan offers this transfer at this time and if not, when they plan to offer it.
If the direct transfer can be made and is made by the end of the year following employee’s death, the children can use their own remaining life expectancy to determine their RMDs. Regardless of the amounts taken from the plan, they will be taxable, but if the children can stretch out the distributions they will get the advantage of both deferring taxes on the remaining balance as well as limiting the amount of taxable income reportable in any specific year.
You are correct that the children CANNOT roll over the funds to their own IRA, it must be kept in inherited IRA status, and the account can only be moved by direct transfer, not by rollover.
If the plan does not offer the transfer, perhaps he should transfer the 401k to an IRA now so that the timing of his death does not have a negative effect on his beneficiaries.
http://benefitslink.com/IRS/notice2007-7.pdf
Permalink Submitted by William Tuttle on Thu, 2008-08-21 20:22
You are essentially correct. The PPA (Pension Protection Act) of 2006 among other things allowed the direct trustee-trustee rollover of a 401k to an inherited IRA. The kicker is that the IRS made this optional on the part of the plan. Under no circumstances can a non-spouse beneficiary rollover an inherited 401k into their own IRA.
Unless there is a substantial compelling reason (creditor/liabilty protection, exceptional funds, low expense ratios, etc.), I would always recommend that where possible the 401k be rolled over to an IRA now.
Usually, IRAs have better investment options than most 401k plans. They generally have lower fees. The beneficiaries can then usually create the Inherited IRA at the same institution. Much less chance of the beneficiary inadvertently busting the stretch capability by getting a rollover check instead of a trustee-trustee transfer.
At a minimum your client should determine if “his” 401k plan allows non-spouse rollovers. However, I would still advise rolling over to an IRA, lack of a compelling reason to stay except for inertia.
Permalink Submitted by William Tuttle on Thu, 2008-08-21 20:42
Sorry I got into a conversation with my boss before I hit submit and essentially duplicated Alan’s post. I hate it when that happens 🙂
A little detail on Alan’s second pargraph. Last year congress was supposed to pass a technical correction to make the rollovers mandatory. The senate passed it and the house did not. However, this year the house has passed it (actually twice, once in March and an addition to the correction in July) and the senate has had it on their calender since April. So it is anybody’s guess when it will actually get passed, and the IRS publishes guidance.
Permalink Submitted by Alan Spross on Thu, 2008-08-21 21:06
And in addition to the Congressional inefficiencies, the IRS itself reversed course from it’s original ruling and then went back to Notice 2007-7. With some luck the next ruling will be logical and permanent. Meanwhile, this risk is best avoided with an IRA transfer now as Bill indicated.