Last summer, shortly after Ian and Brody Bents inherited their father's 401(k) retirement account, Congress enacted a law that seemed to give the brothers a big tax break on their six-figure windfall. It allows anyone who inherits a 401(k) to receive the same favorable tax treatment previously reserved for spouses—specifically, the ability to minimize the up-front tax bill by withdrawing the money over their expected lifetime. But like many others, the brothers have discovered a catch in the legislation: It lets the plans decide whether they want to offer the new benefit. "My dad's 401(k) plan told us it's not required to do anything for us, so we're out of luck," says Ian Bents, 26, who expects to pay combined federal and state income taxes of 41% on his share of his father's 401(k) account this year.
Children, siblings, unmarried partners, and other "nonspouse" beneficiaries have long been subject to onerous rules requiring them to cash out 401(k) inheritances within one to five years of the account owner's death. At that point, the heir would owe income tax on the entire account, since taxes had been deferred. The new law was supposed to change that by putting all beneficiaries on an equal footing with spouses, who have always been free to transfer inherited 401(k)s to an individual retirement account and stretch the withdrawals—and tax bills—over their own life expectancies. But a recent Internal Revenue Service ruling has advisers warning that the new law doesn't offer the protection they hoped it would. As a result, they're instructing 401(k) owners to take steps to ensure that their heirs don't get stuck. "The intention and the reality of the new law are two different things," says Bryan Sweet, Ian Bents's financial adviser in Fairmont, Minn.
The IRS ruling lets employers choose whether to amend their 401(k) plans to make IRA transfers more widely available. While some companies, including IBM (IBM), Eastman Kodak (EK), and MetLife (MET), have done so, many have yet to consider the matter. Some, including the union that oversees the 401(k) the Bents inherited, say they don't expect to take action, in part because making a change costs money. "Companies incur a cost to amend their plans, revise their paperwork, and inform employees of the change," says Ed Slott, editor of newsletter Ed Slott's IRA Advisor. "They also incur the ongoing cost of training and paying employees to handle these distributions. I don't see a lot of companies stepping up to the plate on this."
Even when an employer does its part, heirs who aren't careful can miss out on the new opportunity. According to the IRS ruling, beneficiaries have to transfer their inheritances from a 401(k) plan to an IRA by a specific date, namely the last day of the year after the year in which the account owner dies. The heir of someone who dies this year, for example, must complete a transfer by Dec. 31, 2008. Anyone who inherited a 401(k) from someone who died in 2005 or earlier already has missed this deadline.
If the heirs don't meet the deadline, they still can move their money into an IRA. But they'll lose the ability to spread out the income tax payments over their own life expectancies, says Slott. Instead, he explains, they'll have to liquidate the account on the timetable specified by the rules of the 401(k) plan the money was transferred from. Most require that the entire sum be withdrawn and the taxes paid within five years. "This highly anticipated benefit may not be so beneficial at all," says Theresa Fry, retirement planning specialist at A.G. Edwards & Sons (AGE).
The best way to avoid problems? When you retire or leave a job, transfer your 401(k) to an IRA. That gets your nest egg out from under an employer's rules. You may also be able to take a so-called in-service distribution. A growing number of businesses let employees transfer money out of the plan while they're still on the payroll, says Slott. With an IRA, your heirs will be subject to the more favorable tax treatment.
By Anne Tergesen