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IRS opens up beneficiary options on inherited 401(k)s

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Are you in line to inherit a parent’s 401(k) or other qualified retirement plan account? Due to a recent tax-law change, you have more options at your disposal.

Strategy: Arrange to roll over the funds to a separate IRA. Then you can take your sweet time withdrawing funds under IRS-approved life expectancy tables. Spread out the withdrawals to reduce the overall tax bite.

But be careful to observe all the technicalities in this area. Otherwise, you’ll lose the rollover tax benefit.

Here’s the whole story: Prior to the Pension Protection Act of 2006 (PPA), a nonspouse beneficiary of a qualified retirement plan account couldn’t  transfer inherited funds to his or her own IRA. This option was strictly limited to spousal beneficiaries. Instead, the nonspouse beneficiary often was required to take an immediate lump-sum distribution from the plan or empty out the entire account in just five years. In either event, you were likely to be hit with a massive tax bill.

But Congress lifted some of the restraints. Under a key provision in the PPA, a nonspouse beneficiary is permitted to transfer funds tax-free to an IRA, although it is technically not the same as a rollover. Here’s why:

1. The funds must go directly from the qualified plan to the trustee of your IRA. You can’t lay your hands on the cash. In contrast, a spousal beneficiary has 60 days to redeposit the funds in an IRA, although this will result in automatic withholding on the distribution.

2. The payout must be transferred to a new IRA.You can’t use an IRA you established for yourself in the past. Conversely, a spousal beneficiary may roll over funds into an existing IRA.

3. The IRA account must be properly titled. It should indicate that you’re the beneficiary of the decedent. With a spousal beneficiary, the IRA can be titled in the spouse’s name.

A nonspouse beneficiary can’t wait until after age 70 1/2 to begin taking required minimum distributions (RMDs) from the IRA. This option for RMDs remains available only to spousal beneficiaries.

Example: If you’re 50 years old when you inherit a 401(k), you can stretch out withdrawals based on a life expectancy of 34 years. The exact amount you must withdraw annually depends on whether the plan participant started receiving RMDs before death.

Finally, the IRS threw another monkey wrench into the works last year. In its initial interpretation of the PPA, it ruled that a nonspouse beneficiary inheriting a qualified plan could roll over the funds only if the plan sponsor agreed to accommodate such a transfer. (IRS Notice 2007-7)

But that wasn’t what Congress intended. Subsequently, the IRS indicated that this option must be provided to all nonspouse beneficiaries

Latest word: The IRS has returned to its initial interpretation. However, we expect that new legislation will eventually resolve this matter.

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