Tips for Avoiding Negative Tax Consequences from Your Inherited 401(k)

Historically when the beneficiary of a Qualified Retirement Plan, such as a 401(k), was not a spouse, the account balance had to be distributed in either a lump sum or within a five-year period. Under these rules, the benefit of the tax deferral was lost.

With the passing of the Pension Protection Act of 2006, nonspouse beneficiaries of Qualified Retirement Plans now have the chance to avoid these negative tax consequences and receive the balance through distributions over their lifetime.

Here are some tips that must be followed in order to take advantage of these new rules:

  • Arrange for a trustee-to-trustee transfer from the 401(k) into a new IRA identified as an IRA with respect to the deceased individual (John Smith as beneficiary of Jane Doe’s IRA). This must be a trustee-to-trustee transfer, you cannot receive the money in cash and then roll it into an IRA.
  • Complete the transfer in the year of death if possible, no later than the following year. This way, no matter how the plan was set up, the beneficiary will be able to receive the benefits over their lifetime using the life expectancy rules.
  • If the transfer is completed in the year following the death, be sure to take the required minimum distribution in the year of death.
  • Do not make new contributions to the IRA or roll it over into an IRA solely in the name of the beneficiary.

Be sure to consult with your tax advisor to make sure you have maximized the benefits available to you.