New Rollover Rules  for Inherited Qualified Plans

Good news: With new rules that are part of the Pension Protection Act of 2006, you now have more options

What is a "Qualified Plan?"     Qualified retirement plans include 401(k), profit-sharing and stock bonus plans, as well as pension accounts, Section 403(a) and Section 403(b) annuities, and governmental Section 457 plan accounts.

involving the tax owed on the distribution.

In the case of your Uncle's 401(k) account, the plan will probably cash you out shortly after your Uncle's death by distributing the inherited share of the account balance to you.

Here is a rundown of how the tax rules on that distribution have changed:

Before 2007: Under pre-2007 federal income tax rules, you generally had to pay the resulting tax in the year you received the distribution. In rare cases, the plan would allow you to leave your share in your Uncle's 401(k) account for awhile and thereby continue to defer taxes. But this was the exception rather than the rule.

In any case, you were not allowed to defer taxes by rolling over the distribution from your Uncle's account into an IRA. That tax-saving privilege was only available to spousal beneficiaries. So under the pre-2007 rules, your Uncle's surviving wife could defer taxes by rolling over the distribution of her share of his qualified retirement plan account into an IRA owned by her. But you had no such opportunity.

Basically, non-spousal beneficiaries had few options when they inherited an interest in a deceased person's qualified retirement plan account.

Beginning in 2007: Now, a non-spousal beneficiary of a deceased person's qualified retirement plan account can set up an IRA to receive a tax-free rollover of a plan distribution. (Sources: Section 829 of the Pension Protection Act and Internal Revenue Code Section 402(c)(11))

So you can defer taxes on the distribution from your Uncle's 401(k) account, provided it occurs in 2007 or later. Here are the rollover mechanics necessary to conduct this tax-smart transaction:

1.

Arrange for a trustee-to-trustee transfer. The rollover into a non-spousal beneficiary's receiving IRA must be accomplished with a direct trustee-to-trustee transfer that does not pass through the beneficiary's hands. If the retirement plan issues a check payable to you personally, you cannot do a rollover, and you'll have to include the entire taxable amount of the distribution on your income tax return for the year the payout was received. Technically, the IRA receiving the funds will still be in the deceased person's name, but it will effectively be under your control.

2.

Start taking withdrawals. Once in the receiving IRA, the rolled-over amount falls under the required minimum distribution rules that apply to inherited IRAs. That means you must start taking mandatory annual withdrawals from the IRA under the same rules that would apply if the account had originally been owned by your Uncle and then inherited by you as the designated account beneficiary.

Under these rules, the amount of the annual required minimum withdrawals that you must take  (and pay taxes on) depends on two factors:

• The age of the deceased individual at the time of his or her death.
• The life expectancy divisors based on your age (from an IRS-approved table).

To illustrate how the new rules work, here are a couple of examples:

Example 1

Susan Jones, age 40, is the sole beneficiary of her Uncle John's 401(k) plan account. In 2007, Uncle John passes away at age 63, and Susan inherits the account, which is worth $100,000.

Under the 401(k) plan's operating rules, a beneficiary must be cashed out shortly after a plan participant's death. However, Susan doesn't want to receive a taxable distribution. She prefers to defer the taxes.

So she takes advantage of the non-spousal rollover privilege by setting up a new rollover IRA to receive the $100,000 distribution from Uncle John's account. The receiving IRA is titled "Major Financial Institution, Custodian, for IRA of John Jones, Deceased, Susan Jones, Beneficiary." Susan directs the 401(k) plan trustee to directly transfer the $100,000 into the receiving IRA in a tax-free transaction. She must begin taking annual required minimum withdrawals from the IRA, starting with the year after the year of Uncle John's death (2008 in this example).

Under the required minimum withdrawal rules for inherited IRAs, each annual required minimum withdrawal is calculated by dividing the IRA balance at the end of the previous year by Susan's remaining life expectancy at the end of the withdrawal year.

The mandatory annual withdrawals can be a surprisingly small percentage of the IRA balance, which means the related income taxes can also be small.

Let's say Susan will be 41 years old as of 12/31/08 (the end of the year during which she must take her initial required minimum withdrawal). The mandatory withdrawal for 2008 is only 2.34 percent of the account balance as of 12/31/07. For 2009, the mandatory withdrawal will be only 2.40 percent of account balance as of 12/31/08.

As you can see, it's possible that the IRA will actually continue to grow despite the required annual minimum withdrawals, which is an added tax bonus.

Bottom Line: Susan can benefit from many years of tax deferral if she withdraws only the required minimum amount each year. If she wishes, she can take out more than the annual required minimum amounts, but she will lose part of the tax-deferral advantage if she does that. 

Example 2

Let's assume the same basic facts as in the previous example, except this time assume Susan wants to take $30,000 out of the inherited 401(k) account to buy herself a new car.

Therefore, she directs the trustee of Uncle John's 401(k) plan to issue a check for $30,000 made out in her name. Susan must pay income taxes on the $30,000, but she will not owe the 10 percent premature withdrawal penalty tax that generally applies to retirement account withdrawals taken before age 59 1/2. Why? Because the 10 percent penalty tax doesn't apply to a distribution from a deceased person's account. (Source: Internal Revenue Code Section 72(t)(2)(A))

Susan wants to defer taxes on the remaining $70,000 in Uncle John's account by taking advantage of the IRA rollover privilege. So she directs the trustee to make a direct transfer of that amount into the receiving IRA she has set up. As explained in the previous example, Susan must begin taking annual required minimum withdrawals from the receiving IRA, starting in 2008 (the year after the year of Uncle John's death).

Conclusion

The new IRA rollover privilege can be extremely advantageous for non-spousal retirement account beneficiaries who want to defer taxes. Remember, however, that annual required minimum withdrawals must be taken from the receiving IRA. If the required minimum amount is not withdrawn, a penalty tax equal to 50 percent of the shortfall for the year is owed.

All in all, it's important to consult with your tax adviser if you inherit a significant amount of retirement account money. That way, you can set things up to get the best tax results. The inheritance laws involving retirement plans are complicated and it is not difficult to make an expensive mistake.