Tax relief for 401(k) heirs

Personal Finance

September 19, 2006|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

For years, those who inherited a 401(k) from a parent or partner were left with something else: a big tax bill.

That's because employers typically cashed out the account, and all at once heirs owed income tax on the money. Only surviving spouses could avoid an immediate tax hit by rolling the money into an individual retirement account.

But tax relief is on the way in the new pension law.

Beginning next year, children, domestic partners and anyone else who inherits a 401(k) from someone other than a spouse will be able to transfer the money directly into an IRA. They can then take distributions from the IRA based on their life expectancy, which can be many years. (A 40-year-old today is expected to live another 43 1/2 years.)

Heirs will owe income tax on the withdrawals, but it will be far less than paying the full tax tab at once.

The additional benefit: money sitting in the IRA continues to grow tax-deferred.

"Many beneficiaries will end up getting 10 times more," because of this change, says IRA expert Ed Slott.

As 401(k)s have become commonplace, this change will be a boon for many non-spouse heirs. They are expected to save $157 million in taxes over five years.

Slott warns that these heirs must be careful when setting up an IRA or they can end up getting slapped with taxes anyway.

The money must go directly from the 401(k) to the IRA.

"If you touch the money, it's still taxable," Slott says.

Plus, the IRA must be properly titled in the name of the deceased, include the date of death and specify that it's set up for the heir, Slott says.

"It has to be clear it's an inherited IRA," he says.

Why was Congress so generous?

Slott says the pension law, more than 900 pages, can be summed up in a few words: "You're on your own."

The law creates many tax-friendly opportunities for workers to save rather than rely on an employer or the government for retirement security, he says. Allowing heirs to keep money in an IRA is just one more way to build a nest egg.

Laura Peebles, a director with Deloitte Tax, says she's not so sure all heirs will take advantage of that.

"Like many financial law changes, it benefits those people with money and discipline," she says. "Americans aren't known for their financial discipline."

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