Just a few years ago, many non-spousal inheritors had no tax-deferral option when they inherited all or part of a deceased individual's qualified retirement plan account. By qualified retirement plan, I mean 401(k) plans, profit-sharing plans and the like. For instance, say you inherit your Uncle Henry's 401(k) account. The plan's operating rules may call for completely cashing you out shortly after Uncle Henry's death by distributing his entire account balance to you. Back in the day, you had to pay the resulting income tax hit in the year you received the distribution. Today's rules allow you to defer taxes by rolling over the distribution into an IRA that you control. But you must follow the proper procedure to get this taxpayer-friendly outcome. Here's what non-spousal beneficiaries need to know.
Rollover Mechanics
The rollover into a non-spousal beneficiary's receiving IRA (an IRA set up specifically to receive an inherited retirement plan distribution) must be accomplished via a direct (trustee-to-trustee) transfer that does not pass through the hands of the beneficiary (you). So if Uncle Henry's 401(k) plan issues a check payable to you personally, you can't do an IRA rollover. You'll have to include the entire taxable amount of the distribution on your Form 1040 for the year you receive the payout.
On the other hand, if you arrange to have the check made out to your receiving IRA's trustee (aka custodian), you can accomplish a tax-free rollover. The receiving IRA will still be in the deceased person's name, but it will be under your control. For example, the receiving IRA might be titled something like: "Grand Bank, Custodian, for IRA of Henry Smith, Amanda Smith, Beneficiary."
After the Rollover
The balance in your receiving IRA falls under required minimum withdrawal rules for inherited IRAs. That means you must start taking annual withdrawals from the account under the same rules that would apply if the IRA had been owned by Uncle Henry and then inherited by you as the account beneficiary. For details on how those rules work, see "Inheriting Uncle Henry's IRA". The amount of each annual required withdrawal that you must take from the receiving IRA (and pay taxes on) depends on: (1) the IRA's balance; and (2) the applicable single life expectancy divisor, based on your age at the end of each year. Basically, you are allowed to gradually draw down the balance in the receiving IRA over your life expectancy and potentially reap many years of tax-deferral benefits. Here's an example of how the IRA rollover option can work.
Example: Say you're the sole designated beneficiary of Uncle Henry's 401(k) account. He passes away in 2012 at age 63. You inherit the account, which is worth $100,000. Under the 401(k) plan's operating rules, the beneficiary (you) must be cashed out shortly after the death of the plan participant (Uncle Henry). However, you don't want to receive a taxable distribution. You prefer to defer taxes instead. Here's how.
Step 1: Set up a receiving IRA to take the $100,000 distribution from Uncle Henry's account. (The receiving IRA must be a brand-new account that only holds the money rolled over from Uncle Henry's retirement account.)
Step 2: Instruct the 401(k) plan trustee to directly transfer the $100,000 into the receiving IRA in a tax-free transaction. (If the retirement plan participant -- Uncle Henry -- was older when he died, you might have to take an initial required withdrawal from the plan before rolling over the balance into the receiving IRA.)
Step 3: Comply with the required minimum withdrawal rules each year. Otherwise, you'll owe a penalty equal to 50% of the difference between what you should have taken out each year and what you actually took out (if anything). Ouch! This is one of the most expensive penalties in our beloved Internal Revenue Code.
In our ongoing Uncle Henry example, you must begin taking annual required withdrawals by no later than Dec. 31 of the year after the year of Uncle Henry's death. Therefore, the initial required withdrawal must be taken by Dec. 31, 2013. You calculate the amount of that initial required withdrawal by dividing the receiving IRA's balance as of the end of the previous year (Dec. 31, 2012) by the single life expectancy divisor based on your age as of Dec. 31, 2013. (You can find the divisor in Table 1 of Appendix C in IRS Publication 590 at www.irs.gov.) For each succeeding year, you reduce the divisor by 1.0 to account for your advancing age.
Required annual withdrawals can be a surprisingly small percentage of the receiving IRA's balance, which means the extra income taxes you'll have to pay each year can also be surprisingly small. For instance, say you'll be 41 as of Dec. 31, 2013 (the end of the first required withdrawal year in our example). The initial required withdrawal for 2013 is only 2.34% of the receiving IRA's Dec. 31, 2012 balance (based on a single life expectancy divisor of 42.7 from the IRS table). For 2014, the required withdrawal is only 2.40% of the Dec. 31, 2013 balance (based on a life expectancy divisor of 41.7 -- 42.7 minus 1.0). And so on for each succeeding year. As you can see, it's very possible that your receiving IRA's balance will continue to get bigger despite those darned required annual withdrawals.
The Bottom Line
The IRA rollover privilege is a good deal for non-spousal qualified retirement plan beneficiaries who want to defer taxes. Remember, however, that you must set up a receiving IRA to accept the check from the retirement plan in a direct transfer. Then you must comply with the required minimum withdrawal rules to avoid the dreaded 50% penalty. If you inherit a significant amount of retirement plan money, consider hiring a good tax pro to help keep everything straight.
Rollover Mechanics
The rollover into a non-spousal beneficiary's receiving IRA (an IRA set up specifically to receive an inherited retirement plan distribution) must be accomplished via a direct (trustee-to-trustee) transfer that does not pass through the hands of the beneficiary (you). So if Uncle Henry's 401(k) plan issues a check payable to you personally, you can't do an IRA rollover. You'll have to include the entire taxable amount of the distribution on your Form 1040 for the year you receive the payout.
On the other hand, if you arrange to have the check made out to your receiving IRA's trustee (aka custodian), you can accomplish a tax-free rollover. The receiving IRA will still be in the deceased person's name, but it will be under your control. For example, the receiving IRA might be titled something like: "Grand Bank, Custodian, for IRA of Henry Smith, Amanda Smith, Beneficiary."
After the Rollover
The balance in your receiving IRA falls under required minimum withdrawal rules for inherited IRAs. That means you must start taking annual withdrawals from the account under the same rules that would apply if the IRA had been owned by Uncle Henry and then inherited by you as the account beneficiary. For details on how those rules work, see "Inheriting Uncle Henry's IRA". The amount of each annual required withdrawal that you must take from the receiving IRA (and pay taxes on) depends on: (1) the IRA's balance; and (2) the applicable single life expectancy divisor, based on your age at the end of each year. Basically, you are allowed to gradually draw down the balance in the receiving IRA over your life expectancy and potentially reap many years of tax-deferral benefits. Here's an example of how the IRA rollover option can work.
Example: Say you're the sole designated beneficiary of Uncle Henry's 401(k) account. He passes away in 2012 at age 63. You inherit the account, which is worth $100,000. Under the 401(k) plan's operating rules, the beneficiary (you) must be cashed out shortly after the death of the plan participant (Uncle Henry). However, you don't want to receive a taxable distribution. You prefer to defer taxes instead. Here's how.
Step 1: Set up a receiving IRA to take the $100,000 distribution from Uncle Henry's account. (The receiving IRA must be a brand-new account that only holds the money rolled over from Uncle Henry's retirement account.)
Step 2: Instruct the 401(k) plan trustee to directly transfer the $100,000 into the receiving IRA in a tax-free transaction. (If the retirement plan participant -- Uncle Henry -- was older when he died, you might have to take an initial required withdrawal from the plan before rolling over the balance into the receiving IRA.)
Step 3: Comply with the required minimum withdrawal rules each year. Otherwise, you'll owe a penalty equal to 50% of the difference between what you should have taken out each year and what you actually took out (if anything). Ouch! This is one of the most expensive penalties in our beloved Internal Revenue Code.
In our ongoing Uncle Henry example, you must begin taking annual required withdrawals by no later than Dec. 31 of the year after the year of Uncle Henry's death. Therefore, the initial required withdrawal must be taken by Dec. 31, 2013. You calculate the amount of that initial required withdrawal by dividing the receiving IRA's balance as of the end of the previous year (Dec. 31, 2012) by the single life expectancy divisor based on your age as of Dec. 31, 2013. (You can find the divisor in Table 1 of Appendix C in IRS Publication 590 at www.irs.gov.) For each succeeding year, you reduce the divisor by 1.0 to account for your advancing age.
Required annual withdrawals can be a surprisingly small percentage of the receiving IRA's balance, which means the extra income taxes you'll have to pay each year can also be surprisingly small. For instance, say you'll be 41 as of Dec. 31, 2013 (the end of the first required withdrawal year in our example). The initial required withdrawal for 2013 is only 2.34% of the receiving IRA's Dec. 31, 2012 balance (based on a single life expectancy divisor of 42.7 from the IRS table). For 2014, the required withdrawal is only 2.40% of the Dec. 31, 2013 balance (based on a life expectancy divisor of 41.7 -- 42.7 minus 1.0). And so on for each succeeding year. As you can see, it's very possible that your receiving IRA's balance will continue to get bigger despite those darned required annual withdrawals.
The Bottom Line
The IRA rollover privilege is a good deal for non-spousal qualified retirement plan beneficiaries who want to defer taxes. Remember, however, that you must set up a receiving IRA to accept the check from the retirement plan in a direct transfer. Then you must comply with the required minimum withdrawal rules to avoid the dreaded 50% penalty. If you inherit a significant amount of retirement plan money, consider hiring a good tax pro to help keep everything straight.
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