Post by Zoinkers on Sept 28, 2006 0:42:35 GMT -5
Bankrate.com
401(k) plan beneficiaries get a tax break
Wednesday September 27, 6:00 am ET
Barbara Whelehan
My friend "Rita," a victim of downsizing, was offered a severance package from her employer. Her options: She could take the entire amount as a lump-sum payout or receive it as biweekly paychecks over a six-month period. Rita asked the human resources person with whom she was dealing if she could divert a portion of a lump-sum payout into her 401(k) plan on a pretax basis. The answer she got: Yes, no problem.
But after she received her lump-sum check, she discovered a problem: Her contribution hadn't been deducted. And when she followed up with an HR manager about the matter, she was told that the federal pension rules precluded a contribution to the 401(k) plan in a lump-sum payout scenario. By the time she found out the truth, it was too late to do anything about it.
That's the problem with a lot of decisions we have to make as we navigate our way through tax-related retirement moves. Even when we enlist the help of 401(k) plan administrators or human resources personnel, we may not get the right answers.
Unfortunately, some decisions, such as how we take our retirement-plan distributions, can result in extremely negative consequences. Once a misstep is made, there's no turning back. The new pension law gives us an opportunity to leave a lasting legacy to our beneficiaries from our 401(k) plans -- including those who are not our spouses. Or it provides an opportunity to make a financial foible. Take your pick.
Setting up the kids for a fall -- or windfall
Baby boomers often have complex family lives: second or even third spouses, children from previous marriages, nonspouse domestic partners, etc. The decision of how much money to leave and to whom to leave it to, if in the event of a premature exit from this earthly plane, can be very complicated.
For married folks with 401(k) plans, the default beneficiary is normally the spouse. If you plan to leave a portion of your 401(k) to anyone else (children from a previous marriage, for example) your spouse has to sign off on it and a notary has to witness the signature.
If a spouse inherits a 401(k) plan, he or she can roll over the proceeds into an IRA with no tax consequences. A slam-dunk move. But nonspouse beneficiaries generally have to take a distribution within five years -- and sometimes immediately. Then they must pay income taxes for the year they take the distribution and are not entitled to the tax-deferral benefits of a sanctioned retirement plan.
This all changes next year, due to a provision in the new pension law. Beginning in 2007, nonspousal beneficiaries can get the benefit of a "stretch" -- the ability to extend distributions over their lifetimes. But H.R. folks who handle 401(k) plans generally won't embrace the task of doling out the funds to beneficiaries.
"They don't want the administrative headaches of keeping track of the beneficiaries of their ex-deceased employees as they travel around the world, paying them out for 50 years," says IRA tax expert Ed Slott. "They're just going to hit them with a check -- 'Goodbye! Good luck!' -- and get the account off the books."
And don't count on the 401(k) plan administrators to know how the money should be transferred to beneficiaries in the most tax-effective way, either. It's tricky. The only one you can really count on is yourself.
Why a lump-sum payout is a bad idea
Let's say Sylvester passes away unexpectedly and leaves 50 percent of his 401(k) plan to his wife, Thelma, and 50 percent to his son, Clarence, age 23. The account is worth $1 million. Thelma and Clarence don't do anything immediately. They wait until the new law takes effect in 2007. Then Thelma, a sensible woman, rolls over her portion of the assets into her existing IRA account. Clarence, wanting to impress his mother, does the same.
Uh-oh. Clarence made a mistake: He can't directly roll over the funds, he discovers. Too late. He will have to recognize $500,000 as income in 2007. Though he makes a modest annual salary of $35,000 as a teacher, he suddenly finds himself in the 35-percent tax bracket. He owes roughly $187,000 in taxes for the year, not including state income taxes, if any. And after indulging $100,000 in a 2007 Porsche 911 Carrera two-door convertible, he's whittled the funds down to just over $200,000. After all, now that the money's so handy in the ole' bank account, he finds it extremely easy to satisfy his whims.
OK, even if he doesn't get the car, he's still down almost 200 grand -- a huge cut for Uncle Sam. And then any future earnings are subject to taxation.
The alternative scenario: If Clarence transfers the assets into a properly titled inherited IRA, he could limit his first withdrawal amount at age 24 to $8,460. His account balance of $491,540 could continue to grow in the tax-deferred vehicle, thereby allowing him to take distributions over his lifetime. He would not owe tens of thousands of dollars in taxes.
These same benefits are already in place for nonspousal beneficiaries of IRA plans. But the beneficiaries must follow the same procedures to get the tax break.
How to claim the inheritance
Nonspousal beneficiaries of 401(k) plans must follow the steps outlined below or suffer severe consequences.
The proper way to do a nonspousal 401(k) transaction:
Do a trustee-to-trustee transfer, not a rollover, to a properly titled "inherited IRA."
The deceased IRA owner's name must appear on the account.
The titling would look like this: Sylvester Jones IRA deceased (date of death) FBO (for the benefit of) Clarence Jones.
The check cannot be made out to Clarence directly.
The check cannot go into Clarence's existing IRA.
If the 401(k) plan administrator doesn't want to handle the trustee-to-trustee transfer, make sure the check is issued to the inherited IRA that's titled properly, as described above.
Beginning in the year following death, the beneficiary must take the minimum required distribution (or a higher amount as needed)
Funds build up in the tax-deferred account, and payments may last over the lifetime of the beneficiary.
Company stock in the 401(k)
If a 401(k) plan contains employer stock, beneficiaries can take advantage of a tax break known as "Net Unrealized Appreciation," or NUA, which enables them to pay tax just on the cost of the shares. This provision was in place before the new pension law went into effect, and it has applied to both account holders and their beneficiaries. But to maximize the tax break, this is one time when you want to move the stock into a taxable brokerage account rather than a tax-deferred account.
To qualify for the tax break, the entire plan balance would have to be emptied in one year.
"In the past, a beneficiary would have had to take out everything, and the noncompany stock assets would have been taxable immediately," says Slott. "Now the noncompany stock assets can be transferred to a properly titled inherited IRA, and the stock can be put in a brokerage account.
"You don't sell the shares in the plan," says Slott. "If you do, you blow the tax break." Instead, the stock shares are transferred as stock in kind. Then you pay tax only on the cost of the shares, and you don't pay any more tax until the stock shares are sold.
So, for example, let's say a beneficiary inherits a 401(k) plan worth $1.5 million from a parent. Half of it is in company stock shares. The assets that are not company stock go into a properly titled inherited IRA via a trustee-to-trustee transfer. The company stock shares get transferred in kind into a brokerage account. Let's say the cost of the shares was $75,000. The beneficiary pays ordinary income tax on the $75,000 and doesn't pay any more tax until the shares are sold. At that point, only long-term capital gains rates apply, currently a maximum of 15 percent. The shares get long-term gains treatment the day after the transfer -- you don't have to wait a year.
Nothing in life is easy -- not even inheriting 401(k) money. That's why it's important not only for you to understand it, but also for you to impart the information to your nonspousal beneficiaries so that they can take advantage of these tax breaks. Because once you're dead, there's really no turning back.
Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning. If you have a comment or suggestion about this column, write to Boomer Bucks.
401(k) plan beneficiaries get a tax break
Wednesday September 27, 6:00 am ET
Barbara Whelehan
My friend "Rita," a victim of downsizing, was offered a severance package from her employer. Her options: She could take the entire amount as a lump-sum payout or receive it as biweekly paychecks over a six-month period. Rita asked the human resources person with whom she was dealing if she could divert a portion of a lump-sum payout into her 401(k) plan on a pretax basis. The answer she got: Yes, no problem.
But after she received her lump-sum check, she discovered a problem: Her contribution hadn't been deducted. And when she followed up with an HR manager about the matter, she was told that the federal pension rules precluded a contribution to the 401(k) plan in a lump-sum payout scenario. By the time she found out the truth, it was too late to do anything about it.
That's the problem with a lot of decisions we have to make as we navigate our way through tax-related retirement moves. Even when we enlist the help of 401(k) plan administrators or human resources personnel, we may not get the right answers.
Unfortunately, some decisions, such as how we take our retirement-plan distributions, can result in extremely negative consequences. Once a misstep is made, there's no turning back. The new pension law gives us an opportunity to leave a lasting legacy to our beneficiaries from our 401(k) plans -- including those who are not our spouses. Or it provides an opportunity to make a financial foible. Take your pick.
Setting up the kids for a fall -- or windfall
Baby boomers often have complex family lives: second or even third spouses, children from previous marriages, nonspouse domestic partners, etc. The decision of how much money to leave and to whom to leave it to, if in the event of a premature exit from this earthly plane, can be very complicated.
For married folks with 401(k) plans, the default beneficiary is normally the spouse. If you plan to leave a portion of your 401(k) to anyone else (children from a previous marriage, for example) your spouse has to sign off on it and a notary has to witness the signature.
If a spouse inherits a 401(k) plan, he or she can roll over the proceeds into an IRA with no tax consequences. A slam-dunk move. But nonspouse beneficiaries generally have to take a distribution within five years -- and sometimes immediately. Then they must pay income taxes for the year they take the distribution and are not entitled to the tax-deferral benefits of a sanctioned retirement plan.
This all changes next year, due to a provision in the new pension law. Beginning in 2007, nonspousal beneficiaries can get the benefit of a "stretch" -- the ability to extend distributions over their lifetimes. But H.R. folks who handle 401(k) plans generally won't embrace the task of doling out the funds to beneficiaries.
"They don't want the administrative headaches of keeping track of the beneficiaries of their ex-deceased employees as they travel around the world, paying them out for 50 years," says IRA tax expert Ed Slott. "They're just going to hit them with a check -- 'Goodbye! Good luck!' -- and get the account off the books."
And don't count on the 401(k) plan administrators to know how the money should be transferred to beneficiaries in the most tax-effective way, either. It's tricky. The only one you can really count on is yourself.
Why a lump-sum payout is a bad idea
Let's say Sylvester passes away unexpectedly and leaves 50 percent of his 401(k) plan to his wife, Thelma, and 50 percent to his son, Clarence, age 23. The account is worth $1 million. Thelma and Clarence don't do anything immediately. They wait until the new law takes effect in 2007. Then Thelma, a sensible woman, rolls over her portion of the assets into her existing IRA account. Clarence, wanting to impress his mother, does the same.
Uh-oh. Clarence made a mistake: He can't directly roll over the funds, he discovers. Too late. He will have to recognize $500,000 as income in 2007. Though he makes a modest annual salary of $35,000 as a teacher, he suddenly finds himself in the 35-percent tax bracket. He owes roughly $187,000 in taxes for the year, not including state income taxes, if any. And after indulging $100,000 in a 2007 Porsche 911 Carrera two-door convertible, he's whittled the funds down to just over $200,000. After all, now that the money's so handy in the ole' bank account, he finds it extremely easy to satisfy his whims.
OK, even if he doesn't get the car, he's still down almost 200 grand -- a huge cut for Uncle Sam. And then any future earnings are subject to taxation.
The alternative scenario: If Clarence transfers the assets into a properly titled inherited IRA, he could limit his first withdrawal amount at age 24 to $8,460. His account balance of $491,540 could continue to grow in the tax-deferred vehicle, thereby allowing him to take distributions over his lifetime. He would not owe tens of thousands of dollars in taxes.
These same benefits are already in place for nonspousal beneficiaries of IRA plans. But the beneficiaries must follow the same procedures to get the tax break.
How to claim the inheritance
Nonspousal beneficiaries of 401(k) plans must follow the steps outlined below or suffer severe consequences.
The proper way to do a nonspousal 401(k) transaction:
Do a trustee-to-trustee transfer, not a rollover, to a properly titled "inherited IRA."
The deceased IRA owner's name must appear on the account.
The titling would look like this: Sylvester Jones IRA deceased (date of death) FBO (for the benefit of) Clarence Jones.
The check cannot be made out to Clarence directly.
The check cannot go into Clarence's existing IRA.
If the 401(k) plan administrator doesn't want to handle the trustee-to-trustee transfer, make sure the check is issued to the inherited IRA that's titled properly, as described above.
Beginning in the year following death, the beneficiary must take the minimum required distribution (or a higher amount as needed)
Funds build up in the tax-deferred account, and payments may last over the lifetime of the beneficiary.
Company stock in the 401(k)
If a 401(k) plan contains employer stock, beneficiaries can take advantage of a tax break known as "Net Unrealized Appreciation," or NUA, which enables them to pay tax just on the cost of the shares. This provision was in place before the new pension law went into effect, and it has applied to both account holders and their beneficiaries. But to maximize the tax break, this is one time when you want to move the stock into a taxable brokerage account rather than a tax-deferred account.
To qualify for the tax break, the entire plan balance would have to be emptied in one year.
"In the past, a beneficiary would have had to take out everything, and the noncompany stock assets would have been taxable immediately," says Slott. "Now the noncompany stock assets can be transferred to a properly titled inherited IRA, and the stock can be put in a brokerage account.
"You don't sell the shares in the plan," says Slott. "If you do, you blow the tax break." Instead, the stock shares are transferred as stock in kind. Then you pay tax only on the cost of the shares, and you don't pay any more tax until the stock shares are sold.
So, for example, let's say a beneficiary inherits a 401(k) plan worth $1.5 million from a parent. Half of it is in company stock shares. The assets that are not company stock go into a properly titled inherited IRA via a trustee-to-trustee transfer. The company stock shares get transferred in kind into a brokerage account. Let's say the cost of the shares was $75,000. The beneficiary pays ordinary income tax on the $75,000 and doesn't pay any more tax until the shares are sold. At that point, only long-term capital gains rates apply, currently a maximum of 15 percent. The shares get long-term gains treatment the day after the transfer -- you don't have to wait a year.
Nothing in life is easy -- not even inheriting 401(k) money. That's why it's important not only for you to understand it, but also for you to impart the information to your nonspousal beneficiaries so that they can take advantage of these tax breaks. Because once you're dead, there's really no turning back.
Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning. If you have a comment or suggestion about this column, write to Boomer Bucks.