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New pension law adds flexibility to inherited 401(k)s

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in Small Business Tax,Small Business Tax Deduction Strategies

Common situation: As the beneficiary of a parent’s 401(k) plan, you’re entitled to receive a big lump-sum distribution from the plan. The 401(k) requires you to take the payout within a year of the plan participant’s death.

Strategy: Don’t do anything until next year. Then, roll over the plan funds into an IRA. That will enable you to stretch out payments over several years … maybe even decades.

It’s all due to a king-size tax break in the new Pension Protection Act of 2006, which President Bush signed Aug. 17. The new tax law allows nonspouse beneficiaries to use the same IRA-rollover techniques that—until now—were reserved only for spousal beneficiaries.

The new provision takes effect for distributions received after 2006. So, if you’ve recently inherited assets from a relative’s plan, hold on just a few months longer.

The whole story: When a participant in a 401(k) or other qualified retirement plan dies, the plan may require the account assets to be distributed to the designated beneficiaries in a lump sum, usually within five years, if not sooner. A spousal beneficiary can take the distribution or elect to roll it over into his or her IRA, which provides a tax deferral on the 401(k) payout.

Until now, nonspouse beneficiaries couldn’t roll over funds into an IRA.Instead, they had to receive the distribution under the plan terms, which often resulted in a big tax hit.

In contrast, with an inherited IRA, a nonspousal beneficiary must take distributions according to the required minimum distribution (RMD) rules. The exact method depends on whether or not distributions have begun (i.e., if the participant has reached age 701/2):
  • If distributions have started, the remaining IRA assets must be distributed at least as rapidly as the distribution method being used at the time of death.
  •  If distributions haven’t started, all IRA assets must be distributed within five years of death or over the beneficiary’s life expectancy, beginning in the year after death. 

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