Retirement

Estate Planning and Your 401(k)

by Nancy Osborne, COO of ERATE®

Dec 2, 2007 - Without adequate estate planning as much as 70% of your over all estate could be lost to probate costs and taxes.  It takes months for an estate to be probated and for a judge's final ruling to result, however if one is named as beneficiary of a 401(k), access to the funds should be permitted even prior to the remainder of the estate being released from probate.  But once you've reached that point, then come the taxes.  The last thing you'd want to happen is for your hard earned retirement savings to be siphoned away from your heirs and go directly back into Uncle Sam's pockets.  At the same time, as an heir, you want to be sure not to make any moves yourself which may trigger unintentional tax consequences.  The funds received from a 401(k) or IRA can work to bump an heir or recipient into a higher tax bracket as they will face not only federal income taxes but state taxes as well.  Heirs or beneficiaries of a 401(k) or IRA may also find themselves falling victim to the infamous “alternative minimum tax” or AMT which prevents taxpayers from taking too many deductions and slipping through tax loopholes to minimize or avoid paying taxes.  And if the estate in question is in excess of $2 million dollars then the so called “death tax” may apply which assesses a 47% federal tax on the estate.  

The good news is that inheriting a 401(k) became somewhat easier at the beginning of this year.  Up until now a spouse has been allowed to roll over the assets of an inherited 401(k) into an IRA spreading out the tax liability but unfortunately non-spouses were not granted this same privilege.  A non-spouse was required to withdraw funds from the 401(k) within a period of one to five years, essentially forcing them to pay taxes at both the federal and state level.  However new legislation passed just this year permits both non-spouses and children to transfer an inherited 401(k) into an IRA as well.  Therefore if you are named as beneficiary to a 401(k) by someone other than your spouse, a good path to take would be to open a separate IRA to transfer these fund into, such as a stretch IRA, which will allow you to withdraw and draw out the tax payments on the funds over the course of your life rather than all at once.  Note if you were to transfer funds into an existing IRA which you already have open it would immediately trigger a tax bill, better not to commingle accounts and to keep them separate, always.   However you will need to pay some of the taxes on the funds as well as any estate taxes due but this new law will help you drag out or postpone the tax burden. 

It is vitally important to recognize that every 401(k) plan has its own set of rules and guidelines and although the IRS mandates criteria for a plan, the plan's originators can make their plan even more restrictive than the IRS requires if they wish to.  Therefore once you've inherited a 401(k), your first order of business should be to familiarize yourself with the parameters and guidelines of the particular plan to be sure you maintain compliance not only with the IRS guidelines but with the guidelines of the plan itself.  

Always consult with your tax or financial and legal advisors regarding your own individual circumstances before taking any action which could have a significant impact on your personal taxes or finances.

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Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.

"I am addicted to Bloomberg TV" says Nancy.