What You Need to Know When You Inherit a 401k
The death of a loved one inevitably causes distress. However difficult it may be to focus on finances at such a time, there are certain things you'll need to know - especially for tax planning - if you are the beneficiary of that person's 401k plan.
How the 401k is Treated for Tax Purposes
When a person dies, his or her 401k becomes part of his or her taxable estate. However, a beneficiary generally won't have to wait until probate is completed to receive the account balance.
"As the named beneficiary of the plan, you should be able to access the money even while the rest of the estate is in probate," said Fred Mutter, tax manager at Deloitte and Touche.
You will need to pay income tax on the amount you receive (in addition to any estate tax owed), but there are different strategies you may be able to use to spread out or delay the tax burden, especially if you are the spouse*.
There are other considerations also. For example, you may qualify for a federal income tax deduction if the 401k account is also subject to federal estate tax, which will generally be the case if the taxable estate is over $650,000. (That amount is being raised each year, and will be $1 million in 2006.)
All 401k Plans Are Not Created Equal
When looking at your options for receiving money from a 401k plan as a beneficiary, it is important to realize that each 401k plan has its own set of rules. The IRS sets the outside limits of what plans may do, but a plan is allowed to be more restrictive than that general framework. For example, the IRS may say it is OK for you to leave your 401k inheritance in the account for years without touching it (or paying taxes on it), but the plan rules may stipulate that you take it out sooner.
If you inherit someone's 401k account, the first thing you should do is look at the plan document or summary plan description of the 401k plan to find out what rules will apply to your situation. It is a good idea to ask a tax professional for help, as this can be complicated.
Rules may also differ depending on whether the person who died was your spouse, and whether he or she was already receiving periodic payments from the account.
The Most Likely Scenario: A Lump Sum Distribution
The most likely scenario is that you will need to take the money out of the account in one fell swoop, called a lump-sum distribution. "Most plans will decide automatically to kick out the money," says Cindy McCabe, Senior Manager in Employee Benefits Tax Services at Deloitte and Touche in San Francisco. "They do this for administrative reasons," so they don't have to use resources to keep track of the account of an employee who is no longer there.
The lump sum you receive will be subject to local, state and federal income tax. However, you will not have to pay the 10% early withdrawal tax even if you and/or the deceased person are under 59 ½ (the age at which account holders are allowed to start withdrawing money from their accounts without a penalty).
If you are the spouse, you are allowed to roll the money over into an IRA. This way, you can avoid paying taxes until you make withdrawals from your IRA. You should consider a direct rollover, asking the plan sponsor (employer) to transfer the money directly to the financial institution that houses your IRA. If you receive the check yourself, things become more complicated because the employer will have to withhold 20% for the IRS, and you will have to remember to deposit the check in your IRA within 60 days, otherwise the whole amount will be taxed.
If the plan contains company stock, you should check with a tax professional on possible strategies for reducing taxes when cashing it out.
Stretching Out the Payments
Any beneficiary, spouse or not, may be able to receive payments from the account over a period of years, spreading out the tax hit. This depends on the rules of the particular plan.
If the account holder was already receiving payments from the 401k plan when he or she died, you may be able to continue receiving payments over the same time period. You may be able to speed up the payments and receive larger sums over a shorter time period. However, you may not slow them down to receive smaller payments over a longer period of time. You may also receive a lump sum distribution, or (if you are the spouse) roll the money over into an IRA.
If the 401k holder had not already set up a payment schedule before he or she died, you may still be able to set up your own payment schedule, either over five years or over your life expectancy, if the plan allows it.
If this is an option, you normally have until December 31st of the year after the person dies to decide whether you prefer the five-year option or the life-expectancy option. If you don't specify a choice by then, the life expectancy will automatically be used for a spouse, and the five-year method will automatically be used for a non-spouse.
(You should be able to get the life expectancy figures from the plan sponsor; they are also available from the IRS at http://www.irs.gov.)
Under this option, if you are the spouse you have another decision to make. You may either start receiving the payments by the end of the year following your spouse's death, or by the end of the year during which your spouse would have turned 70 ½.
If you are NOT the spouse, you will have to start receiving the payments by the end of the year following the person's death. In other words, you don't have the same possibilities as the spouse for postponing receipt of the taxable income.
Keep in mind, however, that many plans aren't set up to allow periodic payments because of the administrative costs involved.
As you can see, there are tax implications no matter what strategy you choose for receiving the 401k funds you inherit.
If you are the beneficiary of someone else's 401k plan, you should consider consulting a tax professional who can help you determine what options you have for receiving the money, and the income tax consequences of the different options.
Says Mr. Mutter, the tax manager, "this isn't the kind of calculation you want to do yourself on the back of an envelope."
This was the second article of a two-part series. The first article was What You Need to Know About Naming a Beneficiary.
* Note: The term "spouse" is no longer restricted to members of the opposite sex, but now includes those same-sex spouses in otherwise valid marriages.
The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.