Seven Common Errors 401k Beneficiaries Make
By Arthur S. Leaffer. Mr. Leaffer is founder of Retirement Programs Marketing, a consulting firm for financial institutions' retirement programs.
Have you recently inherited a 401k?
Many beneficiaries assume that there isn't much to do but close the account and spend or invest the money. But, if you do so without carefully investigating your options, you might be making a very costly mistake.
Why? Because the tax rules that govern an inherited 401k are complex and confusing. In certain situations, action is required on your part; in others, no action is required. If you were married to the participant, you may have more options than if you were not the spouse. The only rule of thumb is that ignorance of the rules can lead to costly missteps.
We can't make you a tax expert but we can try to alert you to some common errors that beneficiaries make. This list isn't exhaustive, so before you take action, we encourage you to get guidance and help from a CPA or attorney familiar with 401k inheritance rules.
1. Neglecting to Report Your Withdrawals to the Tax Authorities
Once you inherit a 401k, any money that you receive from it is reported to the federal (and possibly state) government by the 401k trustee under your Social Security number. The deceased participant's name and Social Security number are no longer used for tax reporting.
When you file your income taxes, you are responsible for reporting the withdrawal and paying taxes on any portion that is taxable. Although 401k distributions are usually taxable, it's possible that the employer allowed the participant to make nondeductible contributions to the 401k. Nondeductible contributions are not subject to income tax when withdrawn. To learn whether nondeductible contributions may have been made to a 401k, look carefully at the account statement. If you don't understand what it says, talk to a benefits administrator who can explain the details. The 401k trustee will report distributions to the IRS on Form 1099R, which identifies the taxable and nontaxable amounts.
2. Closing the Inherited 401k Immediately
Although 401k plan terms vary, you generally are not required to close your inherited 401k immediately. You can usually keep the account open and allow it to grow tax-deferred for many years. This is true whether you are the participant's spouse or child, or someone completely unrelated. If the plan does require that all the money be withdrawn, a spouse beneficiary may roll the distribution over to an IRA but other beneficiaries may not.
By closing the account immediately, you will receive the entire amount during a single tax year. Your distribution will be subject to federal (and possibly state) income taxes. If the amount is significant, the windfall may push you up to a higher tax bracket.
When distributions must start: 401k plans differ in their distribution requirements; the following explanation assumes that the plan permits as much flexibility as is allowed by law.
If required minimum distributions to the participant had already begun before death, they must continue at least as rapidly after the participant's death as before. If required distributions hadn't begun, the following rules apply:
A spouse beneficiary has the flexibility to delay taking required distributions from a 401k until the year the deceased participant would have reached age 70½. The spouse beneficiary may also roll the account over to an IRA.
A nonspouse beneficiary must start taking required distributions from the 401k by the end of the year following the year in which the participant died. The required amounts are calculated so that they are approximately equal over the beneficiary's life expectancy, determined using special IRS tables. If distributions do not begin within this period, the nonspouse beneficiary must close the account within five years from the end of the year in which the participant died.
Taxation: Apart from rollovers to an IRA, all money distributed from a 401k is taxable except amounts that represent the return of nondeductible contributions, determined under IRS rules.
Nondeductible contributions: Some plans allow employees to contribute money on which they have already paid income tax and defer taxes on investment earnings. Investment earnings withdrawn from the plan are subject to federal (and possibly state) income tax. You can learn if there are after-tax contributions to the plan by reviewing your account statement.
Generally, IRS rules treat nondeductible contributions as being paid out as a pro rata portion of any distribution -- you cannot take out only the nondeductible contributions. (Some plans that went into effect in 1986 or earlier are governed by a different rule allowing nondeductible contributions to be paid out faster.)
Special tax rules: If the participant was born before Jan. 1, 1936 and you take out the whole balance of his or her 401k in one year, you may be eligible to have the distribution taxed under a special method known as "10-year averaging." This might be an advantageous treatment -- consult with a tax advisor to determine if you qualify.
3. Ignoring the Inherited 401k until You Really Need the Money
If you don't need the money right away, it may make sense to keep the account open as long as possible. As long as the money stays invested in the 401k, your funds can continue to grow tax-deferred. Further, you may have the option of actively investing the account. If you trade within the 401k, there is generally no income tax liability on appreciated securities that you sell and no tax reporting that you need to worry about.
However, the tax rules make it unwise for you to simply ignore your account until you really need the money. If you delay taking distributions from your account beyond certain deadlines, you face substantial tax penalties.
The rules are different for spouse and nonspouse beneficiaries:
Spouse beneficiary: As the spouse of the participant, you have a great deal of flexibility. The rules are generally structured to let you keep the money in your 401k for many years.
Generally, you can keep the account open. If your spouse was over age 70½ and already taking required minimum distributions at the time of death, the general rule is that the minimum payout must continue at least as rapidly after his or her death as before. No. 7 below for a possible exception in this situation.) If your spouse hadn't started withdrawing required distributions, you can defer withdrawing any money from the account until the year your deceased spouse would have reached 70½.
As a spouse beneficiary, you have the choice of keeping the account as a "beneficiary account" in the 401k or doing a rollover to your own IRA. If the account is maintained as a beneficiary 401k in the name of the original participant, you can take withdrawals without owing a penalty if you are under age 59½. If you roll over the account to an IRA in your name, you will be subject to early withdrawal penalties until you reach 59½.
Nonspouse beneficiary: If you are anyone other than the spouse of the participant, the tax rules give you fewer alternatives than a spouse beneficiary. Fortunately, you do have some flexibility to spread the withdrawals over an extended period.
If the participant already began required minimum distributions before he or she died, you must continue to receive payments at the same rate or faster.
If required distributions from the account haven't yet begun, you can generally keep the account open for a long period. To do so, you must start taking minimum withdrawals based upon your life expectancy by the end of the year following the death of the participant. Once you begin, you may keep the account open until all the money is withdrawn (unless the 401k plan terminates first). If you do not start minimum withdrawals within this period, you are required to close the account within five years from the end of the year that the participant died. If the account is not closed within this period, you may face substantial tax penalties.
It makes sense to get guidance and help from an accountant or attorney who specializes in these matters.
4. Expecting to Pay an Early Withdrawal Penalty on Any Money That You Withdraw If You Are Under 59½
Even if you are younger than 59½ when you inherit a 401k, money that you withdraw from the inherited account will not be subject to the 10 percent early distribution penalty tax. If you are the spouse of the participant, you have the option of rolling the account over to an IRA in your own name. If you choose to do so, once the money is in the IRA, the early withdrawal penalty will apply to you.
5. Thinking That You Must Close the Account Immediately If a Trust Was the Named Beneficiary
For estate planning reasons, a 401k participant will sometimes designate a trust and not an individual as the beneficiary. Often it is assumed without detailed analysis that because the beneficiary was a trust, the money must be withdrawn immediately.
However, each trust document is different. In certain situations, you may be able to treat the inherited account as though you were the named beneficiary. In other situations, you may have no choice but to close the account immediately. Before you act, you should have a professional specializing in this area review the trust document and help you understand your options.
6. Assuming That You Can't Roll the Inherited Account to an IRA
A spouse beneficiary generally has the option of rolling the account over to an IRA. A nonspouse beneficiary doesn't have this option. Additionally, it may make sense for a spouse beneficiary not to roll over to an IRA (see No. 3 above).
7. If You Are the Spouse of the Deceased Account Owner, Thinking That You Are Required to Continue Required Minimum Distributions
If you're a spouse beneficiary who has not yet reached age 70½, you can roll over the account into your own IRA, even if the participant already started required minimum distributions. The effect of the rollover is to stop the required minimum distributions. You won't be required to start distributions from your IRA until the calendar year after you reach 70½.
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