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Inherit a 401K? Great! Now How Will You Pay the Taxes??

by Fern LaRocca CFP®

in 401K,401k Contribution Limits,401k Contribution Limits,401k limits,401K Maximum,401k Withdrawal

Only spouses have been able to avoid a large tax bill when they inherit a 401K. The new tax law now allows non-spouses (children and other family members) opportunities to avoid taxes on inherited 401K money.

Typically the spouse is allowed to take the lump sum distribution from a 401K and roll it over to their own IRA where it can grow tax deferred. Tax deferral allows the money to grow fast. When the spouse turns 70 1/2 years old, he/she is required to take minimum distributions from the IRA. A lot of 401K plans don’t give non-spouse beneficiaries the same option. They are forced to take the money out of the 401k plan and pay taxes on the lump sum distribution all in one year.

Starting January 1, 2010, a new law that is part of the economic-recovery package Congress approved late last year, non-spouse beneficiaries will be able to rollover their lump sum distribution from a 401k that they inherited to their own Inherited IRA. An Inherited IRA will make the named non-spouse beneficiary take distributions stretched out over their lifetime. The tax bill will be a lot less than if they had to take the lump sum. It also helps the non-spouse beneficiary which is usually the children not blow through the money as fast as if they had all of it in one year.

A lot of problems can occur when the receiving custodian usually a bank or brokerage firm does not handle the paperwork for an Inherited IRA correctly. Obviously this is something they don’t do everyday and a lot of mistakes have been made where the money was rolled over into a personal IRA instead of an Inherited IRA. Make sure the firm you work with knows and understands how to do this or else it could cost you time and unexpected taxable income or penalties.

When inheriting the proceeds from a 401K, you can avoid a large tax bill. Follow the guidelines above to stretch the money over your lifetime in order to add to your financial plan and lower your tax liability.

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