This is the story of Al, Bob and Carl. Each cousin is the non-spouse beneficiary of his father’s 401(k) plan. Their fathers worked together at the local automotive factory for their entire lives and were all covered by the same plan. The default distribution option in the plan for non-spouse beneficiaries is a five-year payout.
Al’s father named Al on the beneficiary form for the 401(k) plan after his wife died. When Al’s father died, Al knew he wanted to stretch distributions from the inherited plan funds. He did some research and talked to the plan’s representative. Al got some good advice. He did a direct transfer from the plan to an inherited IRA. In the year after his father’s death, Al took his first required minimum distribution (RMD) from the inherited funds.
Al met the tax code requirements and was able to use the stretch payout option in his inherited IRA. 1) He was named on the beneficiary form, 2) he moved the funds in a direct transfer to a properly titled inherited IRA by December 31st of the year after his father’s death, and 3) he took his first RMD in the year after his father’s death.
Bob’s father also named him on the beneficiary form for the 401(k) plan after his wife died. But after his father’s death, Bob did nothing about the inherited 401(k) plan funds. He just let them sit in the 401(k) plan. Then one day, about five years after his father died, he got a letter from the plan. It said that Bob had to take all the funds out of the 401(k) plan before year end. If the plan did not hear from him, they were going to issue a check payable to Bob on December 15th.
At this point, Bob looked into doing a direct transfer of the inherited plan funds to an inherited IRA but it was too late. Bob did not meet the deadline of December 31st of the year after his father’s death and he did not timely take his first RMD. Bob couldn’t move any of the funds to an inherited IRA now because of the five-year payout rule in the plan. Since he was in the fifth year after his father’s death, the entire plan balance was his RMD for the year and an RMD cannot be rolled over.
Carl’s father never paid much attention to details. One detail that he neglected was his beneficiary form. He never filled one out. Since Carl’s parents were divorced, there was no named beneficiary for the plan so it defaulted to his father’s estate. Carl was the sole beneficiary of the estate so he ended up inheriting the 401(k) assets.
Carl also wanted to stretch distributions from the inherited plan funds. Unfortunately, Carl does not have this option. Since he inherited the plan funds through his father’s estate, the tax code does not allow Carl to do a direct rollover to a properly titled inherited IRA. Carl is required to leave the funds in the plan and to take distributions according to the plan rules. That means that Carl will have to take the entire 401(k) balance out by the end of five years. The distributions will be taxable to Carl as he takes them. He can spread them over the five years or wait and take out the entire balance in the fifth year.
The moral of these stories is that the beneficiary form is the key to a good outcome. Make sure they are up to date for all accounts with a beneficiary form, such as IRAs, employer plans, insurance policies and annuities. It is also important for beneficiaries to know what the rules are for distributions after the account owner’s death. A mistake can mean the end of the inherited account and income tax on the account balance.
By Beverly DeVeny, Director of Retirement Education
Gregory Ricks & Associates is a Registered Investment Advisor. We are an independent firm helping individuals create retirement strategies using a variety of insurance and investment products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic financial planning strategies and should not be construed as financial advice. All investments are subject to risk, including the complete loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.
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