Your Estate Matters
New IRS rules reduce flexibility for 401(k) beneficiaries
MANY of us have worked hard to save for retirement and have large sums in our 401(k) or other retirement plans at work.
Thanks to consistent funding over many years and the power of compounding, these funds can be the basis for a comfortable retirement, especially with the uncertainty surrounding Social Security and employer pension plans that may be inadequate or non-existent.
Congratulations if you've saved (or are saving) your own money for retirement in a 401(k) or similar plan.
Often, though, we're so busy funding our retirement that we give little thought to what will happen when funds are withdrawn from the plans. We take pleasure seeing balances grow, and in knowing that funding the plan reduces our current income taxes. But what about later?
Eventually, the proverbial chickens will come home to roost, and funds will have to be withdrawn. The IRS has multiple and complex rules regarding how this must be done. There are penalties for early or late withdrawals, and for withdrawing too much or too little.
There are also rules that penalize your heirs for not taking distributions quickly enough after you die. Some retirement plans may even require that your heirs must receive a lump sum distribution of the entire plan balance if you die.
USUALLY a spouse who is named beneficiary on a 401(k) or similar retirement plan does not have the same problems with distributions as a non-spouse heir.
If your funds are in an IRA, a non-spouse heir can usually convert the IRA to an "inherited IRA" and payments can be made over the life expectancy of that heir.
This can be quite a long time, if the heir is a young person like a grandchild, allowing for maximum deferral of income and minimum income tax.
However, when the funds are in a 401(k) or similar plan, the plan agreement usually requires that the funds must be distributed in a single lump sum at your death. All the deferred income taxes are owed immediately. As much as 40 percent of the value of the IRA can be lost to income taxes.
Last year, Congress decided that it was unfair to not allow heirs to rollover the funds from a 401(k) or similar plan into an inherited IRA.
The Pension Reform Act of 2006 added a new section to the Internal Revenue Code, and starting this year, any "designated beneficiary" may rollover funds from a 401(k) plan into an inherited IRA.
However, Congress also gave the IRS authority to issue rules regarding the rollovers from 401(k) and similar plans. In newly issued IRA Notice 2007-7, the IRS stated that retirement plans do not have to allow the rollover to an inherited IRA. Since many plan administrators do not like any additional administrative burden, it's likely that plans will continue to simply require lump sum payments to any beneficiaries except spouses.
The impact of this notice and other legal complexities of the Pension Reform Act of 2006 are still uncertain. We do know that at retirement, for maximum tax deferral, it's still a good strategy to rollover your 401(k) or similar plan assets into an IRA. Most IRA agreements do allow for inherited IRAs for heirs.
Most of us now understand that saving for retirement is vital. While you're building your retirement assets, remember to consider that you and your family will want to avoid unexpected tax traps related to those assets.
A qualified estate and retirement planning attorney can guide you to avoid tax traps -- and that may go a long way in helping you to enjoy your retirement.
Attorneys Judith Lee Sterling and Michelle H. Tucker, of Sterling & Tucker, can be reached through www.sterlingandtucker.com
or by calling (808) 531-5391.