The recent Pension Protection Act offers good news for the non-spouse
beneficiary of a 401(k). It is now possible to arrange a trustee-to-trustee
transfer of an inherited 401(k) to an inherited IRA. This is great news for the
consumer, and represents a significant change from the old law.
The new
law basically offers inherited 401(k)s the same tax treatment as inherited IRAs.
The 401(k) owner should now make the decision to rollover or not to rollover
based on investment reasons, not tax reasons.
401(k) Rollover
Distribution BackgroundUnder the old tax laws, leaving money in a
401(k) to an heir other than your spouse carried the potential for a tax
nightmare. Rules governing 401(k)s vary according to a particular company’s plan
documents. Often plan documents stipulated that if you left your 401(k) to an
heir, other than your spouse, he or she would have to take distribution of the
inherited 401(k) and pay income taxes on the entire distribution the year after
the death of the original owner.
On a $1M inherited 401(k) this would
mean paying $350,000 in taxes immediately, and the remaining $650,000 would be
outside of the tax-deferred environment. Inherited IRAs did not have that
limitation. An heir with a $1M inherited IRA could take the necessary minimum
required distributions and maintain the money in the tax-deferred
environment—stretching the IRA’s life. And the “stretch IRA" would continue to
grow tax-deferred, and could be worth $1M or more over time for the non-spouse
heir.
Therefore, the best tax advice used to be “roll the money into an
IRA."
The Roll The Money Into An IRA ProblemThe reason
people resisted the advice and rolling the 401(k) into an IRA is that many of
these old 401(k) plans have a great fixed income fund as one of their
components. Many of these old fixed income funds are paying returns in excess of
today’s fixed income or bond funds and many of the old timers continue to have
money in these fixed income funds of their 401(k) 10 years or more after they
retire.
The old law forced a choice between offering the non-spouse heir
the tax benefits of the stretch IRA and the owner’s interest in keeping the
money in the better-than-average fixed income fund in the 401(k). Maybe some
hotshot investor could show me a much better investment than these old funds,
but with my experience, I would rather have money in many of these fixed income
funds (including TIAA for the 403(b) crowd) than other bond or fixed income
funds.
The New Law and My Solution: Make the Best of Both
OptionsI am still in favor of managed money if you find a low fee,
ethical advisor with a great track record. Now, however, I would likely
recommend retaining the fixed income portion of the portfolio in the 401(k). The
stock and growth portion of the 401(k) could be rolled into an IRA to take
advantage of the broader spectrum of investment options offered through IRAs. In
either case the non-spouse heir will not have to worry about the tax
consequences if he or she is lucky enough to inherit either the IRA or the
401(k).
As one of the country’s top IRA experts and author of Retire
Secure!, James Lange, can keep you from jeopardizing your family’s security. He
has developed tax-savvy retirement and estate plans for over 800 U.S. citizens
with appreciable assets in their IRAs and 401(k) plans. Your family’s future
depends on you signing up now for his monthly Retire Secure newsletter at
http//www.paytaxeslater.com
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