New Rollover Option for Inherited Accounts

This week, Gail provides details about the new pension law that offers a big boost to beneficiaries.

Dear Gail,

My favorite uncle passed away unexpectedly in June. He was 63 years old. He never married, so he had no wife or kids. To my surprise, he left his entire 401(k) to me. It’s more money than I’ve ever handled in my life- $326,000 — and I don’t want to make a mistake. More importantly, I want to honor Uncle Carl’s memory by taking good care of this gift he’s left me.

The letter from his company retirement plan says I’ve got two years to close out his account. My friend told me I should “roll it over” into my IRA, but I’m not sure how to do that.

I’m 38. Does this make sense?

Dear Megan-

I’m so sorry that you have lost your uncle. Clearly, you were a favorite of his, as well. By naming you as the beneficiary of his company-sponsored retirement plan, Uncle Carl has given you an opportunity to make your own future more financially secure — provided you make the right decisions about how you handle this gift.

The key is to understand that Uncle Carl’s 401(k) is potentially worth a lot more than $326,000.

First, your friend’s advice is both wrong … and right. Or, more accurately, it’s premature.

Under current law only a surviving spouse can roll an inherited retirement plan into his or her own IRA. However, thanks to the Pension Protection Act of 2006, which was just signed into law by President Bush, starting January 1st this privilege is extended to non-spouse beneficiaries for the first time ever.

The benefit of “rolling” this money into an IRA is that you can postpone having to pay income tax on it all at once. Instead, just a small amount will have to be withdrawn each year, leaving the rest of the money invested inside the IRA where it can continue to compound and grow on a tax-deferred basis.

Here’s the difference: If you close out your uncle’s 401(k) account this year, you’ll lose about one-third of it to federal income taxes alone.

On the other hand, if you wait until January, you can rollover the value of Uncle Carl’s 401(k) into an 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, 2007.

As a non-spouse beneficiary, your life expectancy is based on your age in the year after your uncle died. In 2007 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 In addition, let’s assume that over this period the investments in this IRA earn an average annual return of 8 percent and that, although you’re free to take out more, you only withdraw the minimum amount required each year.

Your first withdrawal (2007) 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. 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, Uncle Carl’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.

But you’ve got to be sure to do this by the book. Nick Kaster, a senior analyst at tax information provider CCH, says the new 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 Uncle Carl’s 401(k) account until next year when this strategy becomes available.

Second, insist that the trustee of Uncle Carl’s 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. As odd as this sounds, Uncle Carl will be listed as the “owner;” with the proceeds payable to you as the beneficiary. (This is the same arrangement you would have if you inherited your uncle’s IRA instead of his company retirement plan.)

Very important: The inherited IRA should be a completely new IRA set up specifically to receive the balance in your uncle’s 401(k) account. Do not co-mingle, i.e. mix, the money from Uncle Carl’s 401(k) with other IRAs you already have — ever.

According to CPA Robert Keebler, this new ability for non-spouse beneficiaries “to take (inherited) money from a qualified plan and move it into an IRA” is the most significant provision affecting individual investors in the entire 900-page Pension Protection Act.

Keebler, with the Green Bay firm of Virchow, Krause, raises another important consideration. Let’s say your uncle died last year instead of this past June. In that case, your first required minimum distribution would have to be taken by December 31st of this year.

Before you instruct the 401(k) administrator to transfer Uncle Carl’s account balance to an inherited IRA, you should “make sure you get your required minimum distributions out.” Once you get your RMDs current, then have the 401(k) money transferred.

I know this is a lot to digest. Frankly, IRA providers are going to be scrambling over the next few months to create new systems and forms to prepare for this change. But I have no doubt that when January 2007 arrives, they’ll be ready to assist you.

But don’t just accept the first IRA custodian you come across or base your choice on the one that has the cheapest annual fee. In my opinion, the most important consideration revolves around the investment choices an IRA custodian offers. The returns Uncle Carl’s rollover earns will drive the size of the distributions you’ll receive. So take a close look at the track records of the investments — probably mutual funds — offered.

Finally, you’re right, $326,000 is a lot of money. It would make a lot of sense to seek the advice of an investment professional. You have to be sure this is done correctly.

You’re lucky to have had such a thoughtful uncle.

Best wishes,

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