This is How You Convert An Inherited 401(k) to a Roth IRA

2 December 2011 6 Comments Print This Post Email This Post

One of the provisions that is available to the individual who inherits a 401(k) or other Qualified Retirement Plan (QRP) is the ability to convert the fund to a Roth IRA.

This gives the beneficiary of the original QRP the option of having all of the tax paid up front on the account, and then all growth in the account in the future is tax free, as with all Roth IRA accounts.

What’s a bit different about this kind of conversion is that, since it came from an inherited account, the beneficiary must take distribution of the account over his or her lifetime, according to the single life table.  This means that, in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.

A downside to this move is that the heir should be in a position to pay the tax on the account from other funds, otherwise the tax pulled from the account will drastically reduce the funds that can grow over time.

If the heir has an IRA of his or her own that could be converted, and there are only enough other funds for paying tax to enable the conversion of one account or the other, the IRA should be converted rather than the QRP.  This is because the IRA has a much better chance for long-term growth than the inherited QRP due to the requirement for distribution of the account (as discussed above).

This is yet another reason that an individual might want to leave funds in a 401(k) plan rather than rolling it over to an IRA – since the heir does not have this Roth conversion option available if the money is in a traditional IRA.  This option is only available for an inherited 401(k) or QRP.

  • dcdoc

    “…in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.”

    To be sure, the younger the heir is, the longer a period of time over which distributions can be taken, and hence the greater the potential benefit. But when is it ever NOT beneficial for an heir to go this route, that is to “stretch” for as long as possible? Even if the heir were 85 years old, and thus without the prospect of a long stretch, would there not still be a possible benefit and no downside risk?

  • dcdoc

    If the funds are in a solo Roth 401(k) plan when the accountholder dies, can the beneficiary leave the funds in that plan for some period of time (up to how long?) rather than taking them in a lump sum payout/distribution; taking them over the course of 5 years; or taking them over the course of their lifetimes? Is it a matter of what the 401(k) plan allows, or does the tax code preclude leaving the assets in a 401(k) account after the accountholder’s death?

    A Roth 401(k) investor can use leverage to buy real estate and not have to pay taxes on income from rents or gains when the real estate is sold; a Roth IRA investor who did the same thing, i.e., used leverage to buy the property, would have to pay UDFI (unrelated debt financed income) taxes on the income and any realized gains. So if the decedent had leveraged real estate as part of the assets within their retirement account, their heirs would be much better off if the account was a 401(k) one and they could continue to hold the assets in the 401(k) plan rather than receive them into their own inherited Roth IRA.

  • http://www.bfponline.com/ Jim Blankenship, CFP®, EA

    Gene,

    Yes, that’s correct.

    jb

  • http://www.bfponline.com/ Jim Blankenship, CFP®, EA

    Dave,

    I think you should be able to roll those funds over into separate inherited IRAs – is the custodian telling you that you can’t? I believe the primary thing that the current custodian can do is make you distribute the money within 5 years – if it’s rolled over to separate inherited IRAs it should be none of their business.

    jb

  • gene

    JIM
    My wife will inherit my 401K and I thought that in 2007 the tax law was changed so that a 401K was to be treated the same as an IRA.

    So my wife upon my death, would withdraw on the single life table(we are same age0. When she dies our children
    can convert remainder of 401K to inherited IRA and withdraw on single life table.

    Is this correct?

    Thank you

  • Dave

    Jim; My brother and I are the non beneficiary heirs of our sister’s employer run 401(K)plan. I am the Administrator of her estate. It appears that we can not “roll over” into our own IRAs, but are there other strategies we can use to continue “tax delayed” growth?