Entrust Learning Center > 2. Account Types > Inherited IRA and Now 401(k) Assets: Making the Best Choice as a Beneficiary

Inherited IRA and Now 401(k) Assets: Making the Best Choice as a Beneficiary

You have inherited an IRA Traditional or Roth or, now, a 401(k) plan (effective 2008).

These are valuable assets, but the value can greatly increase or diminish depending upon the choices you make as a beneficiary.

Making the right decisions can be challenging at a time when you have other stressful matters on your mind. You may have found the rules for inherited IRAs unexpectedly confusing. There are two key things to keep in mind:  One, you have choices, and two, you will want to protect the value of your inherited assets. First, let’s take a look at your choices.

The choices you have are the stepping stones to maintaining the value of the IRA or 401(k) should you desire to do so. First choice you have is to take a total distribution of the assets. Should you do this and the IRA is a Traditional IRA or if it is a 401(k), you will experience taxation but no penalty for early withdrawal, even if your under 59 ½.  If the IRA is a Roth IRA, you may receive the assets tax free if the individual you inherited the assets from maintained the IRA for 5 years.

Another choice you have that will assist you in protecting the value of the IRA is to begin to take annual distributions over your own life expectancy. This allows you to choose the investment of your choice, allowing the IRA to continue to grow while satisfying the IRS rule of taking annual distributions from the IRA as a beneficiary.  You will need to commence these distributions no later than December 31st of the year following the year of death if you are a non-spouse beneficiary. A spouse can move the IRA into his or her own IRA and maintain control as an IRA holder.

Another choice is to draw the IRA value down to zero within 5 years following the year of death.  This will maintain the value of the IRA for a small period of time while you decide.

But you’ve got to be sure to do this by the book. The law is very specific about the steps a non-spouse beneficiary must follow in order to rollover inherited retirement plan assets.
The first requirement is simple—don’t touch the account until you have established an inherited IRA.

Second, insist that the trustee of the IRA or retirement plan send the money directly to something called an “inherited IRA.”  If the trustee cuts you a check and tells you to deposit it into the IRA, you lose the ability to stretch out the withdrawals. You want the assets in the plan delivered via what’s called a “trustee-to-trustee transfer.”
An “inherited IRA” is sometimes called a “beneficiary IRA.” In either case, it must be established in the decedent’s name, not yours. Example: John Smith as Beneficiary of Mary Larson’s IRA.

Very important—the inherited IRA should be a completely new IRA set up specifically to receive the balance in the IRA or 401(k) account. Don’t ever co-mingle the money with other IRAs you already have.

Beginning in 2008, there is new ability for non-spouse beneficiaries “to take (inherited) money from a qualified plan (401(k)) and move it into an IRA.”  This is the most significant provision affecting individual investors in the entire 900-page Pension Protection Act.
Let’s look at the financial benefits of an Inherited IRA. Let’s say your Aunt Mary dies leaving you her entire 401(k) of $326,000. If you took this out in a lump sum distribution, you would have tax of over 30% (between state and federal) PLUS lose the ability to invest this in a tax-deferred vehicle. However, if you roll this into an inherited IRA, the result is magnificent.

You can roll over the value of the 401(k) into an “inherited IRA” and just take out the “required minimum distribution” (RMD) each year based on your own life expectancy. The first withdrawal must be made no later than December 31, 2009 for a death occurring in 2008.

As a non-spouse beneficiary, your life expectancy is based on your age in the year after your aunt died. In 2008, you’ll be 39, giving you a life expectancy of 44.6 years, according to the IRS Single Life Expectancy Table (see IRS Publication 590 at www.irs.gov),. In addition, let’s assume that over this period the investments in this IRA earn an average annual return of 8%, and although you’re free to take out more, you only withdraw the minimum amount required each year.

Your first withdrawal (2009) will amount to a little less than $8,000. In fact, your total withdrawals for the first ten years add up to approximately $115,000. But for each successive ten year period after that, the cumulative amount you receive more than doubles.

That’s right. From age 49-58, your required minimum withdrawals will total more than $250,000. In the next decade, your withdrawals will exceed $560,000. From age 69 through the year in which you turn 78, you’ll receive more than $1.2 million.
In fact, under the above assumptions, if you simply withdraw the minimum required each year, Aunt Mary’s $326,000 401(k) would provide you with more than $3 million in income over your life expectancy!

This is what’s commonly called “stretching out” the life of an inherited IRA. The younger you are, the longer your life expectancy. This translates into more years of tax-sheltered compounding for the investments in the IRA.

You don’t avoid income tax. You just get to delay paying it. Just taking out the minimum amount each year leaves more money working for you inside the IRA. Even after taxes, you come out far ahead of taking a lump sum distribution.

As a beneficiary, you have a choice. A choice to maintain the value and importance of the tax benefits with an IRA either for a short time or the long term. And you have a choice where your inherited IRA is held during this payout time.

Individual choice is the whole reason Congress created IRAs.

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