What You Can Do With An Inherited 401k

10 March 2011 18 Comments Print This Post Email This Post

While most of the time an inheritance of a Qualified Retirement Plan (QRP) such as a 401(k) or 403(b) can be distributed over the lifespan of the heir, such a stretch distribution is not required by the IRS.  The only thing that the IRS requires of these plans is that they do not prescribe a benefit payout to an heir that is slower than the stretchout over the lifetime of the heir.  This could sometimes mean that the plan requires a lump-sum payout of the plan benefits.

The Problem

Prior to 2006, this could really cause a problem, especially if you don’t need the funds at the time.  In a good situation the plan might require a 5-year payout; for a rough go of it, they might push you to take the entire amount in a lump sum.  Since PPA in 2006, there has been a direct rollover option available to beneficiaries of QRPs.  You can set up an inherited IRA account (using the name of the decedent in the title, such as “John Jones, deceased, FBO Jane Jones”) and then perform a direct, trustee-to-trustee rollover into the IRA from the QRP.

This will satisfy the plan’s requirement for the lump-sum payout, while at the same time giving you the option of stretchout of the distributions over your lifetime.  It is important to note that this rollover must be a direct, trustee-to-trustee rollover – the 60-day rollover cannot be used in this case!

Roth it!

One additional way to deal with such a payout requirement is to convert the QRP directly to an inherited Roth IRA account.  Again, you need to ensure that the account is titled appropriately as mentioned above.  But then you can convert the QRP to the Roth account.

This may be another good reason for leaving your retirement account in a 401(k) plan – since there is still no way that an inherited IRA may be converted to a Roth IRA account.  In this case the heir has the flexibility to convert the funds rather than rolling them over.

A downside to this is that the inherited Roth IRA is required to distribute its funds to the heir over the heir’s lifetime – which is different from your normal Roth IRA.  A standard, owned Roth IRA account does not have to distribute the account’s funds during the lifetime of the owner, but any inherited Roth IRA does.  This is true whether the original account that was inherited was already a Roth IRA, or if it was converted from a QRP into the Roth.

  • Elkton3

    I have a question. I inherited my late husbands 401K 9 years ago. I had the option to keep it with the present financial company, which has worked out well. It is fully vested. I am 59 1/2, am I able to start receiving a monthly distribution, if I so desire? Thank you

  • http://www.inherited401k.com/ Inherited 401(k) Consultants

    Jim,
    That’s true that some Inherited IRAs cannot be converted to Roth IRAs. However, if you inherited the IRA from your spouse, it is perfectly eligible to be converted to a Roth IRA, as it is basically treated as your own IRA at that point. Good article.

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

    Nathaniel,

    Yes, that is an option you can use.

    jb

  • Nathaniel

    Is it possible to take half in cash and rollover the other half?

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

    Sandy -

    First let me offer my condolences for your loss.

    Regarding the 401(k) and when you have to make a move – that’s dependent upon the administrator of the plan. You should get in touch with them to determine if you need to do anything right away, and what options you have available to you.

    In the case of a death, you should be eligible to withdraw funds from the account at any time without penalty. You’ll still have to pay tax on the withdrawals, but no penalty. There may be other limitations on the plan (every plan is a little different) so you need to talk to the administrator to learn your options.

    Best wishes to you.

    jb

  • Sandy

    My husband passed away in January 2012 and I was listed as sole beneficiary to his traditional 401k. I’ve received papers asking me what I want done with this. I am 51 years old and he was 54, so no one was getting payments from the account.

    My husband spent a lifetime accumulating the money, and I don’t want to make a mistake that would undo all his efforts. On the other hand, I don’t want to fritter away the years like Silas Marner by counting my gold and living in near poverty.

    Although I am grieving now, I know that at some point I’ll be healed. I figure I only have so many healthy good years left to enjoy life and I don’t want everything tied up in a retirement account that I can’t touch without penalty.

    What would be the best way to handle this? How long before I have to make a decision?

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

    Ann,

    Whoever is the primary beneficiary of the account is eligible to rollover the account into an inherited IRA and begin taking RMDs from the account. The beneficiary would also be eligible to convert the account to a Roth IRA if desired – RMDs would still be required, but the tax would have been prepaid.

    I’m not sure otherwise what you are asking re: “handling these accounts” – please followup if there are more questions.

    jb

  • ann

    My brother just passed away and left me the beneficiary of at least one of his three 401 plans. The other two plans may be in my parents’names. What’s the least complicated method of handling these accounts, especially when several parties are involved? Thanks so much.

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

    Jane,

    Unfortunately, no – once the money has been distributed (in the case of an inheritance) it can’t be rolled over into an inherited or regular IRA. The rollover has to be a direct, trustee-to-trustee transfer.

    jb

  • Jane

    My father left 70,000 I took it as a lump sum, if I roll it over in the next 60days can I avoid paying tax on it?

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

    Michael,

    You will not have to pay tax on the money, as it will be considered a gift from your sister and she’s already paying tax on it. The end result will be that you will receive a lower amount than she does, but the tax will have already been paid on it, and it won’t be in an IRA account. The tax rate paid on your portion will likely be at a higher rate since it’s being taken in a lump sum in a single year, but you won’t have to deal with required minimum distributions from the account.

    Once it’s all worked through you’ll probably both get a similar amount, all in all.

    jb

  • Michael

    My father just passed away and left his 401k to my sister. She is splitting it with me 50/50. I understand that she will have to pay taxes on the full amount, but when I get my half, minus the tax that was paid on the full amont, do I have to pay tax on it as well? It is in the amont of $42,000 total. We are just waiting on them to transfer the money to an IRA in her name. Am I going to get even less than her in this deal?

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

    Joe -
    The account should have been distributed to an inherited IRA and RMDs taken from it. It’s possible that this could still be done, but I’d talk to the IRS about it. If the answer is that you need to get a Private Letter Ruling (PLR) this can become costly very quickly, so if the account is relatively small you may not want to pursue it.

    If you did get this to happen, your father would have to take distributions for each year after your brother’s death, along with the penalty (which is 50% of the distribution).

    What’s more likely is that your father will have to completely distribute the account by the end of the fifth year following the year of your brother’s death – which is next year, 2012. If the account is sizeable this could mean a relatively large distribution, but there should be no penalties if this is the action taken.

    The RMD holiday in 2009 only applied to retirement RMDs, not RMDs for inherited accounts, so it has no bearing on your father’s situation.

    Hope this helps -

    jb

  • Joe

    Jim-
    This question is for my father. My brother passed away in 2007 (age 31). The name on his 401k account was changed to my fathers as directed by Merrill Lynch. Nothing has been done with that money since. We are concerned about our tax liability and whether we got some bad advice. Another consultant is now saying that that 401k money should have been rolled into an inherited IRA with req’d distributions. At this point, we are just trying to figure out what to do, pay the proper taxes, avoid penalties, do the right thing. We also heard something about required distributions being waived for 2008? Any help would be appreciated. Joe, North Carolina

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

    Audrey -

    Answering your questions in order:

    I believe the payout could be listed on either your husband’s return or on the decedent’s final return, but you’ll need to get more clarification on this from an estate attorney.

    In either case, tax will have to be paid on the amount distributed, but no penalty will apply.

    There is no gift provision, taxes will be due on the entire amount that would otherwise be taxable. If there were a portion of the 401(k) plan that was post-tax contributions, then there would be no tax on that amount, but otherwise everything in the account will be taxed.

    The split to the other heirs should include a reduction for the tax paid (if your husband winds up paying tax on the whole amount).

    Hope this helps -

    jb

  • Audrey

    My husband inherited his father’s 401K. He was listed as beneficiary and MUST take a lump sum payment to split equally with his 4 siblings. On whose tax return for 2011 does the payout get listed – my husband’s, or the deceased’s final return for 2011. Also, is there an early withdrawal penalty and @ what percent. AND – is there an amount that can be “gifted” and doesn’t have to be reported on anyone’s taxes? Please help – this is getting SO confusing. Thank You