Income taxes are likely to be lower for many who inherit 401(k) plan accounts and other employer retirement plan accounts, thanks to the pension reform law the President signed into law in August. The law puts non-spouses closer to an equal footing with spouses who inherit the accounts.
Employers are not required to give heirs the same “stretch out” and other rights granted to beneficiaries of IRAs. Instead, most employers do not want to continue maintaining the accounts for heirs. Employers generally require non-spouse heirs to empty the accounts within five years. Some employers require the accounts to be emptied almost immediately.
The tax law did not allow heirs to defer taxes by rolling over an inherited employer retirement account to an IRA. Spouses could do so, but non-spouse heirs could not. The result of the tax law and employer rules was that non-spouse heirs were forced to take distributions from the inherited accounts within the time frame set by the employer, and the distributions were included in their gross income.
The new law provides tax savings opportunities for non-spouse heirs.
Employers still can require that the accounts be emptied on an accelerated schedule. Now, the heirs can roll the employer accounts into an IRA and defer income taxes.
Spouse heirs still have more rights than non-spouses. A spouse inheriting a retirement account can roll it over into any IRA, including an existing IRA. Once in the account, the money is treated like any other IRA of the spouse’s. Required distributions may be delayed until the spouse is older than age 70½. The process of transferring the account to the IRA also is simple.
On the other hand, to qualify for deferral a non-spouse beneficiary must have the retirement account transferred directly from the employer plan to an IRA. The beneficiary cannot receive a check and deposit that check in an IRA. In addition, the IRA must be created specifically to receive the rollover. Mingling with other IRAs is not allowed.
As with an inherited IRA, the roll over IRA must have the correct account title to qualify for tax deferral. The title must have the name of the deceased, the date of death, FBO (for the benefit of), and the name of the beneficiary. For example, the IRA’s title should be similar to the following: Max Profits IRA, deceased, date of death, FBO Hi Profits as beneficiary.
Once the employer account is transferred correctly to the IRA, the deferral is not unlimited. The heir must begin receiving distributions immediately. But the required distributions can be spread over the beneficiary’s life expectancy as determined in tables issued by the IRS.
For example, a 45-year-old inherits a 401(k) account and has it transferred to an inherited IRA. The first year’s distribution is the amount in the account at the end of the previous year divided by 38.8. That is the number of years’ life expectancy the IRS estimates for the beneficiary. The life expectancy table is available on our members’ web site and also in IRS Publication 590.
The new rules apply to distributions made after 2006. The rules help children, grandchildren, and other loved ones to whom the deceased account owner was not married.