To Give And Receive

How to pass on 401(k) assets and manage an inheritance

If you’re disciplined about saving and investing, you may be fortunate enough to fund your ideal retirement and leave some money to your heirs. But without proper planning, they could face hefty tax bills, returning much of your hard-won retirement savings back to the government. At the same time, if you inherit 401(k) assets, you’ll want to avoid any missteps that trigger unintended tax consequences.

Consider that at the end of 2006, the average 401(k) account balance was $121,202, according to a study conducted by the Employee Benefit Research Institute and the Investment Company Institute. Although that’s not enough to retire on, it makes sense to have a plan to protect your money under any circumstance.

One of the most common mistakes is failing to update account records to reflect the names of designated beneficiaries. For instance, if the account holder or beneficiaries divorce, the names of the designees all too often remain unchanged, says Kevin Pritchett, a financial planner and attorney with Kevin Pritchett & Associates Retirement Planning, Inc., in Westchester, Illinois. “If the information is not updated, those assets can be lost to probate.”

It can take months for a probate court judge to rule on who gets what, and “taxes alone are a huge tidal wave waiting to happen.” All told, without proper planning, Pritchett says as much as 70% of an estate can be lost to taxes and probate costs.

That’s because transferred retirement savings and other assets must run a tax gauntlet. It starts with federal income taxes. Indeed, the proceeds from a 401(k) or IRA can actually boost their recipient into a higher tax bracket. A beneficiary who earns $35,000 a year and inherits $85,000 in 401(k) money could find himself paying income tax of 25% rather than 15%.

State income taxes also take a bite. And if an estate is large enough — $2 million per person this year — the 47% federal “death tax” kicks in. Finally, beneficiaries may find themselves on the hook for the complicated “alternative minimum tax,” intended to ensure that the wealthy don’t skirt taxes through legal loopholes.

Actually, inheriting a 401(k) became more tax friendly at the beginning of this year. Traditionally, a spouse was able to roll over the assets of an inherited 401(k) into an IRA. However, non-spouses were required to withdraw the funds, usually within one to five years after the plan owner dies — thereby forcing them to pay state and federal taxes. Legislation passed last year now allows children and other non-spouses to transfer inherited 401(k) funds into an IRA.

So if you inherit 401(k) funds from someone other than your spouse, you’ll need to set up a separate inherited IRA. Transferring the money into an existing IRA will require you to pay taxes.

Even with the new legislation, there are complexities that you’ll need to investigate fully. In particular, company plans can set their own rules, and they aren’t required to extend this benefit to non-spouses. Consulting with a financial planner may be your best safeguard.

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