Are mandatory payouts enforced for an inherited 401(k)?
My father-in-law recently passed away unexpectedly. My wife is the sole beneficiary. Although he was still currently employed, he was 72 years old and had entered the phase of forced payouts from his pensions, 401(k), etc. So, I'm curious how the account will move forward at this juncture. I would assume the mandatory payouts no longer apply, since he is passed away. My wife and I are mid-30's and have been saving 10% of my own earnings for around 15 years, so I have a good start on my own 401(k), with plenty of time to continue doing so. So, let's say he had $200,000 in his 401(k). What are my options? Should I leave it be as a 401(k) and just change ownership? Should I roll it to an existing IRA (from a previous job) or roll it to a new IRA entirely? I know withdrawals will need to be taxed, but what about penalties to use it, for instance, to payoff an annoying $20K of remaining student loans? Or what if I wanted to use it for something like buying a car or building a home? We still have to work through the sale of his car and home, I realize those funds would be more "liquid" in paying off debts, but for the sake of this question, let's assume the sale of those items just washes out the debt-sale value leaving us with $0 gained/$0 lost.
I am sorry for your loss.
You will be required to take required minimum distributions if you choose to not take the money as a lump sum. The treatment of Inherited retirement accounts, 401(k) or IRA's, is outlined in the IRS guidelines and publications 559, 575, and 590(b) depending on the type of retirement plan.
Generally, inherited (non- spouse) retirement (401(k), IRA) money can be rolled over into the beneficiaries name or you can take a lump sum or some type of distribution. Usually, people will roll the 401(k) and/or traditional IRAs into an account that must be labeled as an inherited IRA that will include the name of the deceased. The inherited IRA funds must be kept separate from other retirement accounts and monies, since your wife must take annual required minimum distributions (RMD) based on her age, for as long as there is money in the account. There are pretty severe penalties for not taking the RMDs, so make sure your tax advisor knows the details of the Inherited account You can take more money out (pay off that loan), but any money taken as a distribution will be added to your income and taxed accordingly in the year of the distribution. If your father in Law had an annuity, retirement or non retirement, or a Roth IRA, they are treated a little differently and due to space and you not mentioning them will not go into them. Also, remember to make sure whoever does the tax returns (final individual and estate) for your father-in-law, make sure he took his RMD in the year of his death. If he was working, generally his work 401(k) is not included in his RMD calculation. I strongly suggest you get some guidance from your tax advisor before making any transfers or filing any tax returns. Inherited Retirement money is not difficult to understand but the rules are very inflexible so get the right help to set up and understand what you can or should not do and the taxable nature of the decisions.
Below is an excerpted paragraph about a non-spouse beneficiary from the IRS website.
This is regarding an inherited retirement plan, inherited from someone other than a spouse."If the inherited traditional IRA is from anyone other than a deceased spouse, the beneficiary cannot treat it as his or her own. This means that the beneficiary cannot make any contributions to the IRA or roll over any amounts into or out of the inherited IRA. However, the beneficiary can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary."
Like the original owner, the beneficiary generally will not owe tax on the assets in the IRA until he or she receives distributions from it.
Beneficiaries of Qualified Plans
Generally, a beneficiary reports pension or annuity income in the same way the plan participant would have reported it. However, some special rules apply.
A beneficiary of an employee who was covered by a retirement plan can exclude from income a portion of non-periodic distributions received that totally relieve the payer from the obligation to pay an annuity. The amount that the beneficiary can exclude is equal to the deceased employee's investment in the contract (cost).
If the beneficiary is entitled to receive a survivor annuity on the death of an employee, the beneficiary can exclude part of each annuity payment as a tax-free recovery of the employee's investment in the contract. The beneficiary must figure the tax-free part of each payment using the method that applies as if he or she were the employee.
Benefits paid to a survivor under a joint and survivor annuity must be included in the surviving spouse’s gross income in the same way the retiree would have included them in gross income.
This can get complicated so you need to contact the 401(k) adminstrator. If your father-in-law annuitized the 401(k) and/or pension, then he may have traded the lump-sum asset off for lifetime income, and when he passes, it may be gone. Or he may have picked some other payout option like over his lifetime, but at least 10 years "sum certain" (at a minimum). This is only one reason I don't like annuitizations.
I am assuming though the way you worded the question he either began taking his pension payments (annuitized it) and was then just taking minimum required distributions (MRDs) for his 401(k) at 70 1/2. If so, then the 401(k) assets are still intact, but the pension may be gone. But if he was simply taking MRDs on all his retirement assets, the entire amounts may have the ability to "roll." The pension is really the wildcard. That said, anything available will generally be able to "roll" into a Beneficiary IRA in your wife's name and in the decedent's name. You cannot commingle a Bene IRA with a one of your wife's existing IRAs and you will see why in a minute. Only spouses can roll their deceased spouse's IRA/401(k), etc., into their own IRA and treat as there own. Therefore, you will want to open a Beneficiary IRA for your wife and establish an account number so the 401(k) plan (and possibly pension) can roll the assets into her "Bene" IRA. You may even have to "convert" the 401(k) titling at the the 401(k) first before you roll to the Beneficiary IRA, but that is up the administrator.
Since the account holder died after 70 1/2 and RMDs have begun, you will have 2 choices as a non-spouse beneficiary has a couple options. You can always take out as a lump-sum which is the worse choice due to taxes on the entire amount. But the other more common option is you can take it out over the life expectancy of the beneficiary. In the life expectancy scenario, distributions must begin no later than the year the original account holder would have reached 70 1/2. There will be no 10% penalties for early withdraw regardless of you wife's age.
This can get pretty tricky so I suggest you get some help in order to execute this correctly to minimize taxes and better control distributions. If done incorrectly, you could trigger a taxable event on the corpus. I would use a fee-based only advisor free of any conflicts of interest that act as your Fiduciary. Additionally, I have attached a webpage from Schwab so you can read the rules for yourself. There are other sites, but this is the most concise, easy to understand list of rules I have seen.
Hope this helps and sorry for your loss. If you need any clarification, reach out to me and I would be happy to let you pick my brain.
Dan Stewart CFA®
In this case, you are going to be required to take the Required Minimum Distributions (RMD). For the year he died, your wife will need to take whatever RMD he was subject to. The second year, the RMD will be calculated using your wife's age and then for every subsequent year, you will reduce the life expectancy by 1. Once you roll this into an IRA, you can work with the brokerage firm to set up automatic RMDs. Once you give them the information they need, they will automatically calculate the RMD each year and send it to you.
Your going to have to roll this into an inherited IRA that will be in the name of your spouse. The same penalties will still apply, if you take withdrawals before age 59 1/2, you will be taxed an additional 10%.
The first thing your spouse should do is contact the company that sponsors your father-in-law's 401(k) to determine what choices the plan allows. You may not be allowed to keep the inherited balance in the plan. Rolling the 401(k) into an IRA is probably a better option, anyway. The IRA would be established as an "Inherited" account and your spouse will continue mandatory distributions your father-in-law had begun, however she can adjust them to reflect her age. The IRS publishes a schedule for these inherited accounts in Publication 590-B Distributions from Individual Retirement Arrangements (IRAs). Look in the Appendix B for the schedule to use as a beneficiary. A person in their mid-30's would be subject to an initial distribution of about 2% of the account balance, or around $4,000, in your example.
She can take any size distribution from the beneficiary IRA, as long as it's enough to meet the minimum requirement. These distributions will not be subject to the 10% early withdrawal penalty, but they will be subject to ordinary income tax in the year they are taken. So, in your example, if she wanted to take $20,000 to pay off a student loan, she could. If you file jointly and are in the 28% marginal tax bracket, the federal tax on the distribution would be $5,600.
Using IRA money to buy a car or other major purchase is an expensive choice because of the tax so carefully examine the economics before the two of you decide to make a big distribution. Finally, the 401(k) distribution should not be combined with other IRA accounts because doing so will void the beneficiary tax treatment without eliminating the distribution requirement.
I'm going to do my best to answer your question, but I have to start with the obligatory "I'm not a CPA, nor do I play one on TV!" Having said that, my understanding is the following:
If you inherit any type of tax qualified account (such as 401(k) or IRA, anything that "qualified" for a tax deduction at the time of funding), you are required to either distribute the entire account out over a set time period (5 years for example) OR you can roll the account into what is called an Inherited IRA. This Inherited IRA allows you to maintain the tax deferral on the account. However, you cannot combine it with any of your other retirement accounts. Also, ALL Inherited IRAs will require a minimum distribution each year. This is similar to what your father-in-law was withdrawing. However, it is based on the age of the person who inherits the account.
I believe taking advantage of the inherited IRA is a great option; and while you may not wish to take the annual distribution, at least you can decide how to make the most of it, whether that is by paying down student loans or doing something else with the money.
I hope that helps, and I wish you success!