Avoiding Deemed Distribution Treatment for Inherited Retirement Funds

by Prof. Robert Bloink and Prof. William H. Byrnes

It’s no secret that the rules governing inherited IRAs and 401(k)s have become increasingly complicated in post-SECURE Act years. Non-spouse beneficiaries who inherit retirement accounts must deal with a host of new complications—and the related tax issues—when evaluating their required minimum distributions (RMD) obligations after the death of the original account owner. RMD planning receives a significant amount of attention (as it should) in determining the best way to minimize overall tax liability. Unfortunately, beneficiaries often overlook one simple step that can inadvertently cause the entire inherited account balance to become currently taxable. The inherited account must be moved to a beneficiary account unless the beneficiary was the original owner’s spouse—and if the wrong method is used for moving the account balance, all of those tax minimization opportunities can be lost.

Moving the Account Balance

Inherited IRAs and 401(k)s are different type of accounts when compared with their original predecessor accounts. Typically, when you own an IRA or 401(k), you’re entitled to consolidate those accounts by rolling over the funds in one account into another without tax liability (while only one IRA-to-IRA rollover is permitted in any 12-month period, the rule does not apply to direct transfers). Non-spouse beneficiaries are not entitled to roll inherited funds into their own IRAs and 401(k)s. They must instead establish a separate beneficiary account that includes both the beneficiary’s name and the original account owner’s name.

How the funds are transferred from the original account to the beneficiary account matters. The key thing to remember is that the funds cannot be paid directly to the beneficiary even if the beneficiary intends to deposit the funds into a beneficiary account.

For IRAs, the transfer should be accomplished via a direct trustee-to-trustee transfer. The existing IRA custodian will cut a check that makes the account balance payable to the new beneficiary IRA. This transaction is not reportable to the IRS. Any beneficiary can use this direct transfer method (including trusts and estates, which are considered non-person beneficiaries).

For qualified plans, the transfer should be accomplished via a direct rollover from the 401(k) or 403(b) plan into a beneficiary IRA. That means the existing plan sponsor transfers the funds directly to the newly established beneficiary IRA. This method, however, is not available to trusts and estates, as non-person beneficiaries.

Depending on the circumstances, a non-spouse beneficiary who is not an eligible designated beneficiary may be permitted to allow the funds to grow tax-deferred for up to ten years. Annual RMDs are required if the original account owner died after their required beginning date—but the beneficiary can still spread the associated tax liability over ten years and realize significant tax-deferred growth.

Transferring the funds in an improper manner can lead to the entire account balance being treated as a distribution. That means the entire amount would be taxable in the year of distribution.

Potential Mistakes to Avoid

It’s important to remember that any RMDs that are currently due from an inherited 401(k) must be taken before the funds can be transferred into the beneficiary account. That makes it important to check with the plan administrator before executing the transfer.

Beneficiaries of Roth IRAs should also be concerned with the method of distribution to the inherited Roth IRA. Non-eligible designated beneficiaries of Roth accounts are also subject to a ten-year withdrawal period (although they are not required to take annual RMDs). It can potentially be valuable to allow the funds to grow over the entire ten-year period, because Roth distributions are not taxable (including earnings in most cases). Using the wrong transfer method can cause the beneficiary to miss out on maximizing the tax-free benefit of the inherited Roth account.

It’s also important to use the right type of beneficiary account. A traditional 401(k), for example, should be transferred into a traditional inherited IRA (properly titled as a beneficiary-designated account). If the traditional account is transferred into a Roth inherited account, the pre-tax dollars are included in the beneficiary’s income during the year of transfer (similar to the tax treatment of a typical Roth conversion).

Conclusion

Non-spouse beneficiaries should immediately be advised about the rules governing movement of inherited retirement account funds. One wrong move can result in the loss of valuable tax savings—and increase the beneficiary’s overall tax liability significantly. It’s important to have a trusted advisor review the details of any proposed transaction to prevent expensive mistakes.