Last year, the Internal Revenue Service (IRS) announced something that skipped by unnoticed by almost every financial planner and accountant in the United States. Heck, there was so much on everybody’s mind last year that a lot of things skipped by unnoticed.
What was skipped over… IRS Notice 2008-30. If you are a non-spouse beneficiary of a 401k or other qualified retirement plan you should pay attention.
Here’s basically what IRS Notice 2008-30 stated… A decedent’s (dead person’s) qualified retirement plan (i.e. 401k, 403b or pension) can be directly rolled over into a Roth IRA for a non-spouse beneficiary (such as a child, sibling, or life partner). The Roth IRA is treated as an inherited IRA rather than the beneficiary’s own IRA.
If a non-spouse beneficiary of an qualified retirement account elects this it is analogous to a Roth IRA conversion. With a regular Roth IRA conversion, a person converts a Traditional IRA into a Roth IRA by reporting the entire amount of the Traditional IRA as distributed and therefore as income to the IRS, there is no 10% early withdrawal penalty applied if under age 59.5. Then with this entire distribution from the Traditional IRA a person deposits it into a Roth IRA.
Therefore, it is taxable income just as if the money had been distributed and then contributed to a Roth IRA. Then the Roth IRA must begin to make annual required minimum distributions based upon the lifetime of the beneficiary starting in the year after the decedent’s death. These annual required minimum distributions are tax-free distributions just like a qualified distribution from a regular Roth IRA.
The Roth IRA works differently than a Traditional IRA. The benefit of a normal Roth IRA is that after an initial period of 5 years AND after age 59.5 any earnings within the Roth IRA can withdrawn tax free. The initial amount contributed to a normal Roth IRA can be withdrawn at any time without any penalty or tax as it is considered after tax money by the IRS. Any earnings withdrawn, with certain exceptions, from a normal Roth IRA are subject to income tax if withdrawn prior to age 59.5 AND before the initial five year holding. There is no income tax deduction for contributions to a Roth IRA per se under normal circumstances. With a normal Roth IRA there are no required minimum distributions for the account owner as there are with a Traditional IRA; after a person’s death the owner of the Beneficiary Roth IRA is required to take minimum distributions just like a Traditional IRA, but the distributions from the Beneficiary Roth IRA are not subject to income tax.
Any use of a Roth IRA is ideal for those who expect to be in a higher tax bracket in retirement versus their current income tax situation. Generally, my advice to my clients is that a Roth IRA is preferable to a Traditional IRA as the current tax environment is known whereas the future tax environment is always unknown.
With the election to rollover a qualified retirement plan to a Roth IRA by a non-spouse beneficiary is best suited for those who are in a low income tax bracket the year the decedent passes away but expect to be in higher tax brackets later in life. For example, a father in his 50s passes away and leaves his 401k to his son who is in his late 20s.
There are of course a few hurdles that must be overcome before a non-spouse beneficiary can elect to roll the qualified retirement plan into a Roth IRA.
1.The decedent’s qualified retirement plan must allow distributions from a deceased employee’s account into an IRA. There is no legal requirement that a qualified retirement plan has to allow such a provision. Most plans of large corporations do allow this.
2.The qualified retirement plan must be an eligible retirement plan under Section 402(c)(11). Most are, so this is really a non-issue.
3.The beneficiary must meet the criteria for a conventional Roth IRA conversion (adjusted gross income below $100,000 in 2009 …no limit in 2010 and later years).
If the non-spouse beneficiary is later found to be ineligible for the direct rollover into a Roth IRA the rollover can be re-characterized as a transfer to a regular IRA.
So here is the crux of all this. If you are a non-spouse beneficiary of a qualified retirement plan you should consider rolling the money into a Roth IRA if it makes sense for your individual tax situation. Why? You should consider this because if you do not elect this option the money will get rolled into a Beneficiary IRA and you cannot later make the election to change the Beneficiary IRA into a Beneficiary Roth IRA. There are no consequences for getting it wrong and having your adjusted gross income (AGI) too high as you can correct the mistake by re-characterizing the rollover as a transfer to a regular IRA.
Another interesting benefit that comes from a non-spouse beneficiary electing to rollover the money to a Roth IRA benefits those situations wherein the decedent has a large estate that will be subject to estate taxes. A beneficiary of retirement assets is entitled to claim an itemized deduction on estate taxes paid for any estate taxes paid on the retirement asset by the estate of the decedent. Thus, while it is usually advantageous to defer income from taxes it can also be advantageous to accelerate income; since the federal estate tax is often higher than income tax the deduction makes sense for large estates that are/will be subject to estate tax. Effectively this can cut the income tax paid by the non-spouse beneficiary who elects to roll the qualified retirement plan to a Roth IRA approximately in half.
This is a one time opportunity that should not be taken lightly if you are going to be a non-spouse beneficiary of a 401k or other qualified retirement plan. To help you make the determination if this strategy is appropriate for you it is recommended that you seek advise from a qualified tax expert and a CERTIFIED FINANCIAL PLANNER™ to help you figure out your tax liability and the implications of this election on your financial plan.
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A common scenario on this topic….
What if, under the duress of the death of your loved one, you do nothing about the 401k and leave it where it is for up to two years after your loved one died? The answer is, the IRS is going to be fairly nice to you.
In Private Letter Ruling 200811028, the IRS allowed a beneficiary who didn’t take the required minimum distribution for the first two years after the decedent’s death was still eligible to receive distributions over their lifetime (“stretch provisions”). Until this ruling was release you would have been automatically forfeited the “stretch” provisions.
If this applies to you, per Private Letter Ruling 200811028, then you, the beneficiary must take all of the missed distributions in the third year and pay the 50% penalty for the money not withdrawn and then you can continue to receive the “stretch” benefits of the IRA.
Written: April 27, 2009
