Tax advantages of inherited IRAs

Depending on the recipient`s age and the size of the original account balance, the tax advantages of rolling retirement plan assets into an inherited IRA can be significant.

Consider an example. Under the previous law, a relatively young nonspouse beneficiary — say, a 35-year-old 401(k) accountholder`s daughter — inheriting account assets worth $500,000 would have had to take that amount as a lump sum, potentially triggering a bill of nearly $200,000 in state and federal taxes.

But provided the deceased parent`s plan allows it, she can now roll the assets over into an inherited IRA and start taking annual minimum required distributions (MRDs). For someone of her age with a $500,000 account balance, the MRD would be $10,309 per year, calculated by dividing the account balance by the term determined by her age. Although the amount that`s distributed is subject to ordinary income tax, the balance of her 401(k) inheritance has the potential to grow tax deferred through the investments of her choice in the inherited IRA account.

Inherited IRA rollover rules

But to reap these tax benefits and other advantages, nonspouse beneficiaries of 401(k), 403(b), or 457 plan assets need to follow the rules for transferring assets very carefully.

To arrange for the transfer of assets to the inherited IRA, the beneficiary will probably have to contact the deceased person’s former employer with a copy of the death certificate and request that a check be issued in the deceased’s name and sent to the institution that will become the new trustee.

It`s important to oversee the details of the transfer carefully, because if the check is accidentally made out in the beneficiary`s own name, the assets will be considered a lump sum distribution and taxes will be due on the entire amount immediately — just as they would have been under the old law. This is the case even if the beneficiary immediately deposits the check into an IRA.

Because of the potential for confusion under the new rules, some experts suggest nonspouse beneficiaries to 401(k)s and similar accounts consult a financial professional or attorney who specializes in retirement planning to set up an inherited IRA before arranging for the transfer of funds.