How inheriting a 401(k) works

Under the new guidelines, qualified 401(k), 403(b), or 457 plans can offer direct IRA rollovers to designated nonspouse beneficiaries. While companies aren`t obligated to provide this benefit, if they make it available, they must offer it on a non-discriminatory basis to employees who wish to name nonspouse beneficiaries.

However, nonspouse beneficiaries can`t just roll plan assets over into their own IRAs the way a surviving husband or wife can. Rather, these beneficiaries must transfer the assets into an entirely new IRA account set up specifically to receive the inherited money, called an inherited IRA. Known as a direct trustee-to-trustee transfer, the money goes directly from the employer`s plan into a new IRA that is titled in both the name of the person who has died and the beneficiary.

Minimum required distributions (MRDs) from inherited IRAs

Unlike spouses, who can delay taking distributions from the IRA they have established with the 401(k) assets until age 70 1/2, nonspouse beneficiaries are required to take annual withdrawals — called minimum required distributions or MRDs — from an inherited IRA. Distributions must start the year after the year in which the original accountholder dies, and the annual withdrawal amount is based on the beneficiary`s life expectancy. So, a 35-year old beneficiary would be able to stretch out his or her withdrawals over 48.5 years. You can find the length of that term in Table I of IRS Publication 590, “Individual Retirement Arrangements (IRAs),” available on the IRS Web site, www.IRS.gov.

Although nonspouse beneficiaries still have to pay tax on the annual withdrawals at their regular income tax rate, the assets that are in the account remain tax-deferred, and the beneficiary can invest them as he or she chooses. This provides the potential for substantial portfolio growth.