Taxation for 401(k) Death Distribution Intestate
A 64 year old decedent had a 401(k) (valued at 120k) without beneficiaries. The estate will not be subject to estate taxes. Three beneficiaries, no spouse, have been listed in the estate paperwork. They vary in age from 26 to 35 and their incomes range from 30k to 100k. The Summary Plan Description calls for a lump sum distribution to estates.
Their initial plan was to have the estate pay the taxes but the effective rate would be around 35.5%. Passing the income to the beneficiaries using form 1041/K-1 (box 5), appears to be the better route in terms of taxes (10-20% at individual rates vs. 35.5% at estate/trust rates).
Is using form 1041 to pass the income to the beneficiaries an established strategy or would it require guidance from the IRS in the form of a PLR or other communication? If form 1041 was used and the IRS later determined that the estate should have paid the taxes rather than the beneficiaries, this would be an 18k+ liquidity problem. I have gotten conflicting guidance from CPAs on this matter, any clarification would be appreciated.
Permalink Submitted by Alan - IRA critic on Mon, 2022-08-22 21:43
While leaving a 401k to an estate is the worst possible situation, worse than leaving an IRA to the estate, the usual lump sum distribution from the plan to the estate can be routinely passed through to the estate beneficiaries on a K-1 and taxed at their individual rates. If the estate has material deductible expenses, some of those expenses can absorb some of the plan distribution and the balance passed through to beneficiaries. Not sure why some CPAs are questioning IRS approval of the pass through to the estate beneficiaries. Not that there is NO WAY to roll any of the plan distribution to an inherited IRA. Participant would have needed to list a qualified trust or individual beneficiary on the 401k for that.
Permalink Submitted by Ken Wachtler on Wed, 2022-08-24 00:12
As executor of my brother’s estate, I am dealing with essentially this exact same issue. Upon requesting a 3-way distribution from the estate 401k to individual IRA’s of each probated beneficiary, I was informed by Fidelity Netbenefits that this is not possible due to IRS regs, and they can only perform a lump-sum distribution to a single non-IRA account. Q1: To achieve K1 pass-through to benefitiaries, must the lump-sum distribution go to a non-IRA estate account, thus estate realizes the income to be passed-through ? Q2: To achieve 3-way distribution , the executor distributes from the non-IRA estate account to non-IRA individual accounts as non-taxable events, correct ? Q3: What IRS document provides guidance on distributions from estate 401k (I can’t find anything) ? THANK YOU SO MUCH 🙂
Permalink Submitted by Alan - IRA critic on Wed, 2022-08-24 00:57
Permalink Submitted by Urban Fleming on Tue, 2022-09-20 14:08
We were able to get the funds directly rolled over to bene IRAs and will use the 5 year rule (coded as a direct rollover, no taxes withheld). We presented the estate documents that listed the beneficiaries and filled out their plan specific forms. I had the requesting firm mail off the 401(k) transfer forms with a letter of acceptance and estate documents. It’s hard to say how rare this is from my perspective but it is obviously plan specific. In Florida, the earliest disbursements can happen is 3 months after publication so a rejected attempt early on is a non-factor. However, a successful attempt at a direct rollover could present liquidity problems since the 401(k)/employer plan can still be accounted for in the estate inventory. In other words, the estate will still need to pay the attorney, accountant, personal representative and any applicable debt. In cases where estates are primarily composed of qualified funds, careful coordination with an attorney, CPA and planner are needed to ensure proper execution.
Permalink Submitted by Alan - IRA critic on Tue, 2022-09-20 15:13
This was not a permitted direct rollover per Sec 402(c)(11), which clearly states that a direct rollover to an inherited IRA is only available to a designated beneficiary of the plan. Plans generally appear to be well aware of this, and as you indicated last month the plan document specifies a lump sum distribution. I don’t know what potential fallout there could be from this error, as the IRS will most likely only look at the direct rollover 1099R forms. The IRS does not know who the plan beneficiaries were. Therefore, something like plan audit possibly triggered by other disallowed activity is the most likely threat to these transactions.
Permalink Submitted by Urban Fleming on Tue, 2022-09-20 17:33
I think you make a great point. Could it be the plan determined that the transactions were appropriate by deeming the estate beneficiaries as designated beneficiaries after review of the estate documents? 26 CFR 1.401(a)(9)-4, points to plans being able to make determinations, not exclusive to named beneficiaries. The client was advised by their tax attorney to pursue this option. Their estate attorney confirmed several of her prior clients have successfully rolled over funds using the method decribed. The Plan is large (in the top 10), I am curious on if they have internal policy I am not aware of that facilitated this. Moreover, I could have missed something in the SPD. In your experience, would a plan audit result in potential penalties against the plan, beneficiaries or both? I will reach out to the tax attorney for more guidance and appreciate your insight!
Permalink Submitted by David Mertz on Tue, 2022-09-20 17:56
See 26 CFR 1.401(a)(9)-4 A-1: “A designated beneficiary is an individual who is designated as a beneficiary under the plan…” A beneficiary of the estate is not a beneficiary designated under the plan. An estate is also not an individual.
Permalink Submitted by Urban Fleming on Tue, 2022-09-20 18:30
“A-1. A designated beneficiary is an individual who is designated as a beneficiary under the plan. An individual may be designated as a beneficiary under the plan either by the terms of the plan or, if the plan so provides, by an affirmative election by the employee (or the employee‘s surviving spouse) specifying the beneficiary.” Could “terms of the plan” be a factor here? “The fact that an employee‘s interest under the plan passes to a certain individual under a will or otherwise under applicable state law does not make that individual a designated beneficiary unless the individual is designated as a beneficiary under the plan.” Does the above passage forbid plans from using estate documents as a means of determining or is it there to provide clarification that estate documents do not override plans?
Permalink Submitted by David Mertz on Tue, 2022-09-20 20:00
Nothing stated in A-1 permits estate documents to be used in determining a designated beneficiary. “Designated as a beneficiary under the plan” means exactly that, a beneficiary designation made by the employee directly to the plan or a default beneficiary specified in the plan agreement (which also must make a surviving spouse the sole beneficiary unless said spouse has previously provided to the plan a waiver of that statutory right). Nothing here permits “designated as a beneficiary under the plan” to be construed to mean beneficiaries of the estate.