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1. Leave the money in the plan
2. Transfer the money to an IRA, or
3. Take the proceeds in cash.
If a beneficiary decides to leave the money in the plan or transfer the proceeds to an IRA (called an “inherited IRA”), the beneficiary must make a decision as to how and when to take distributions from the account. Generally, a beneficiary must determine whether to 1) take a minimum distribution, which may be required to begin in the year following the original account holder’s death and continue each year thereafter or 2) defer distributions until a later date, but then the account must be fully distributed by December 31 of the fifth anniversary of the original account holder’s death. Some plans may not offer lifetime distributions and default to the five-year payout, so it is important to understand the plan’s rules and call the plan administrator with any questions.
If a nonperson, such as a charity, is also named one of the 401(k) plan participant’s beneficiaries, it is imperative to have the nonperson’s portion distributed by September 30 of the year following death, or human beneficiaries will be locked into the five-year payout rule.2
A nonspouse beneficiary may also direct that the proceeds of the participant’s account be transferred to an inherited Roth IRA account, opened in the decedent’s name for the beneficiary’s benefit. This is the only way, other than inheriting a designated Roth 401(k) account, that a nonspouse beneficiary may establish a Roth IRA with 401(k) proceeds. If the account is transferred to a traditional IRA rollover first, a Roth conversion cannot occur. The nonspouse beneficiary would also need to determine how to have distributions made from the inherited Roth IRA account as we described above.
A spouse beneficiary may take possession of the 401(k) proceeds for up to 60 days and then complete the rollover to an IRA. A nonspouse beneficiary does not have this ability, and once assets are distributed, they cannot subsequently be rolled over to an IRA.
Q. What is a minimum (nonspouse) distribution from a qualified plan?
A. Whether there is only one beneficiary or multiple ones, the calculation methodology for the minimum distribution amount is the same. Differences may arise, however, in what life expectancy to use in the calculation, as this depends on the ages and types of beneficiaries named. Distribution minimums are governed by regulations under Internal Revenue Section 401(a) (9).
A simple way to look at this is to determine the age of the oldest or only beneficiary in the year following the death of the original account holder. That age has a corresponding life expectancy factor, which the IRS publishes in Publication 590. For example, the life expectancy of a 45-year-old beneficiary is 38.8 years. The account balance total at the end of the prior plan year is divided by this factor to determine the minimum distribution amount for that year.
Let’s say the hypothetical account balance is $200,000. The minimum distribution amount would then be $200,000 ÷ 38.8 or $5,154.63. Each beneficiary would receive a portion of this dollar amount based on his/her inherited share percentage. So if the original account holder had named two beneficiaries to share the account equally, each beneficiary would receive $2,577.32.
The process is the same each year as the life expectancy factor is reduced by one (37.8, in this case) while the account balance is adjusted for earnings (losses) and the prior distribution. The beneficiary would be wise to name his/her own beneficiary to receive the balance of his/her payments (or the account balance) should he/she not survive the full payout term. A new beneficiary takes up where the last one left off, so if the beneficiary in this hypothetical example passed away after receiving one payment, his/her beneficiary would use the 37.8 factor (38.8 – 1) to determine how large a minimum must be distributed, followed by using 36.8, 35.8, 34.8 etc. A beneficiary generally can accelerate how much he/she will take if the minimum is not sufficient for their needs.
The beneficiaries might also each choose to roll the proceeds over to separate inherited IRA accounts (as described above). As long as the beneficiary established the separate inherited IRA prior to December 31 in the year following the original account holder’s death, the beneficiary is able to utilize his or her own age and perhaps lower the minimum to be received, since younger ages have longer life expectancies.
Q. What happens if you name a minor as your beneficiary?
A. When minors are named beneficiaries, the rules governing the minimum distribution requirements are exactly the same. A 12-year-old sole beneficiary would use a 12-year-old life expectancy (70.8 years) when determining the initial minimum. The issue of naming a minor beneficiary, however, can become problematic, as the plan sponsor cannot distribute the proceeds directly to a minor.
To accommodate this situation, it would likely be ideal, from the plan administrator’s perspective as well as the late participant’s, to have the participant create a trust for the benefit of the minor that would be named as the beneficiary or designate a guardian in his/her will who would be responsible for the minor’s interests. Otherwise, the plan could not make any distributions from the account until a guardian is authorized by the probate court before making a distribution.
Your Next Step
As you have just read, some items can be quite complex, while others somewhat simple. Your situation may not be typical of anything we’ve discussed. We strongly suggest you review all beneficiary options with your advisor, your intended beneficiary, and your tax professional.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.