Inherited 401ks and IRAs-Kathleen Pender 2/07

Last fall, Congress passed a law that gives people who inherit a 401(k) or other workplace account from someone other than a spouse the same tax-saving opportunity they would get if they inherited an IRA from that person.

In January, the Internal Revenue Service issued guidance on the law that was confusing and appeared to be less generous than what Congress had intended. Last week, the IRS clarified its guidance in a way that has tax and retirement professionals grumbling.

"It's worse than what everyone thought the law says and worse than what they thought at the beginning of January," says Barry Picker, a New York City certified public accountant and financial planner.

When you inherit an IRA from someone other than your spouse, you must begin taking distributions from the account, but you can spread them over your lifetime.

When you inherit a 401(k) or other workplace account, however, you must withdraw the money according to the employer's rules.

Most employers force heirs to take out the money in lump sum or over five years. (An exception might be made if the person who died had already started taking the mandatory distributions required after age 70.5, in which case a different distribution schedule might apply.)

Employers can let heirs stay in their 401(k) plans and take the money out gradually over their lifetimes, but most do not allow this. In general, employers are not eager to maintain long-term relationships with the heirs of deceased employees.

Distributions from traditional IRAs and workplace accounts are taxed as ordinary income. From a tax standpoint, it's almost always best to stretch out distributions as long as possible so the money can continue to grow tax deferred.

For this reason, it was usually better to inherit an IRA than a 401(k) or other workplace account, unless you inherited it from a spouse.

Spouses who inherit a workplace account can roll it over into an IRA. Non-spouse beneficiaries didn't have this option, until now.

The Pension Protection Act includes a provision that lets non-spouse beneficiaries roll a qualified employer retirement plan directly into an inherited IRA.

In January, the IRS made it clear that this applies to 401(k) plans as well as 403(b) plans for educational and nonprofit employees, and 457 plans for government employees.

It also issued guidance that surprised many professionals. The guidance implied that the law could only benefit non-spouse beneficiaries who inherited workplace accounts from people who died in 2006 or later.

Many were hoping it would apply retroactively and to anyone who still had money in a workplace account inherited from someone who died before 2006, says Michael Kitces, director of financial planning for Pinnacle Advisory Group in Columbia, Md.

The guidance also suggested that non-spouse beneficiaries could only roll a workplace account into an IRA if the employer's plan allowed such a move. It also seemed to say that plans do not have to permit this.

"We thought they would say it was mandatory," IRA expert Ed Slott says.

Last week, the IRS made it crystal clear that non-spouse beneficiaries can only obtain the stretch benefit from rolling over workplace accounts from people who died in 2006 or later.

And, it reiterated, the plan must allow it.

To qualify for the rollover, non-spouse beneficiaries must take specific steps:

-- Make sure the plan allows such rollovers.

-- Move the money directly from the workplace account to an inherited IRA in a trustee-to-trustee transfer. Beneficiaries should not take possession of the money, even for a moment.

-- Segregate the money in an inherited IRA. Do not mix it with other IRAs.

-- Properly title the account as an inherited IRA. For example, it should say something like "James Smith as beneficiary of John Smith, IRA," says Picker.

-- Complete the rollover and take the required distribution, no later than Dec. 31 of the year following the year of death.

If one or more of these steps are missed, "you could be stuck with the less favorable payout rules of the plan rather than your own life expectancy," says Slott. At worst, the rollover could be disqualified and taxed as ordinary income.

A slightly different rule applies to non-spouse beneficiaries who inherited a workplace account from someone who had already started taking mandatory distributions after age 70.5. These beneficiaries should make sure the plan allows rollovers. If it does, they should take the current year's distribution and roll the rest into an IRA. This can be done no matter what year the person died if the plan allows rollovers, Kitces says.

Beneficiaries should check with an accountant or financial adviser who thoroughly understands these rules. Don't rely on the customer service rep at a financial institution.

It's still not clear whether employers have to formally amend their plan documents to allow rollovers. If they do, they might be reluctant to allow them, at least initially.

Also, if the plan is administered by a mutual fund company whose funds are in the plan, it might discourage the employer from allowing rollovers because the fund company would lose assets, Picker says.

On the other hand, many employers might embrace rollovers to keep their employees happy and encourage their heirs to take their money elsewhere.

Slott says people can spare their heirs this uncertainty by rolling their 401(k) or other workplace plans into their own IRAs as soon as they leave their employers.

"If you have a chance to take control of your money, you should," he says.

For heirs, moving the money to an IRA is a no-brainer.

Suppose a 30-year-old inherits $500,000 in a tax-deferred account. If he takes it out in a lump sum and pays taxes, he'll be forced into the highest tax bracket and have around $300,000 left. If he invests that sum in a taxable account, he will owe tax on the earnings.

But if he leaves it in the tax-deferred account, his distribution in the first few years will be around 2 percent or $10,000 a year, probably not enough to move him into a higher tax bracket.

"We have found that generally speaking, if you are a younger, even a middle-aged beneficiary, if you inherit a half-million dollar account and spread out distributions over your lifetime, you will have taken out a million dollars," says Picker.

The new law probably won't have much impact on the "fairly large percentage" of people who cash in their inherited IRAs and 401(k) accounts to "go on a spending spree," Kitces says.

"For most people who were going to spend it, they will probably spend it," he says. "For people who want to keep saving, (the new law) provides a much more tax-favored way to do it."