Financial Planning Advice: 401(k) Rollover Information your Financial Planner Might not Want to Tell You…

The recent Pension Protection Act offers good news for the non-spouse beneficiary of a 401(k). It is now possible to arrange a trustee-to-trustee transfer of an inherited 401(k) to an inherited IRA. This is great news for the consumer, and represents a significant change from the old law.

The new law basically offers inherited 401(k)s the same tax treatment as inherited IRAs. The 401(k) owner should now make the decision to rollover or not to rollover based on investment reasons, not tax reasons.

401(k) Rollover Distribution Background

Under the old tax laws, leaving money in a 401(k) to an heir other than your spouse carried the potential for a tax nightmare. Rules governing 401(k)s vary according to a particular company’s plan documents. Often plan documents stipulated that if you left your 401(k) to an heir, other than your spouse, he or she would have to take distribution of the inherited 401(k) and pay income taxes on the entire distribution the year after the death of the original owner.

On a $1M inherited 401(k) this would mean paying $350,000 in taxes immediately, and the remaining $650,000 would be outside of the tax-deferred environment. Inherited IRAs did not have that limitation. An heir with a $1M inherited IRA could take the necessary minimum required distributions and maintain the money in the tax-deferred environment—stretching the IRA’s life. And the “stretch IRA” would continue to grow tax-deferred, and could be worth $1M or more over time for the non-spouse heir.

Therefore, the best tax advice used to be “roll the money into an IRA.”

The Roll The Money Into An IRA Problem

The reason people resisted the advice and rolling the 401(k) into an IRA is that many of these old 401(k) plans have a great fixed income fund as one of their components. Many of these old fixed income funds are paying returns in excess of today’s fixed income or bond funds and many of the old timers continue to have money in these fixed income funds of their 401(k) 10 years or more after they retire.

The old law forced a choice between offering the non-spouse heir the tax benefits of the stretch IRA and the owner’s interest in keeping the money in the better-than-average fixed income fund in the 401(k). Maybe some hotshot investor could show me a much better investment than these old funds, but with my experience, I would rather have money in many of these fixed income funds (including TIAA for the 403(b) crowd) than other bond or fixed income funds.

The New Law and My Solution: Make the Best of Both Options

I am still in favor of managed money if you find a low fee, ethical advisor with a great track record. Now, however, I would likely recommend retaining the fixed income portion of the portfolio in the 401(k). The stock and growth portion of the 401(k) could be rolled into an IRA to take advantage of the broader spectrum of investment options offered through IRAs. In either case the non-spouse heir will not have to worry about the tax consequences if he or she is lucky enough to inherit either the IRA or the 401(k).

James Lange