Non-spouse beneficiaries gain from new pension legislation

by Center for Personal Finance editors

FORT COLLINS, Colo. (9/27/06)--The Pension Protection Act of 2006--signed into law by the president last month--provides a tremendous benefit for domestic partners or other non-spouse beneficiaries (sibling, parent, child, and so on) who inherit a 401(k) retirement account when someone dies. Because the changes are effective with payouts beginning in 2007, make sure you understand the rules now (Coloradoan.com Sept. 10).

There's good reason for the change. Current law has harsh income tax consequences for non-spouse beneficiaries who inherit a 401(k) or other employer plan balance. Why? Non-spouse beneficiaries are generally forced to collect the entire balance within five years following the owner-decedent's death, and some employer plans require that the payout be made within one year or as a lump sum.

Either way, the result is a huge tax burden because the inherited amounts that cannot be rolled into an individual retirement account (IRA) are taxable in the year they are distributed. The payout is added to the beneficiary's other income, often pushing them into a higher tax bracket.

In contrast, payouts to the decedent's spouse from a 401(k) or profit-sharing account balance can be rolled over into the surviving spouse's IRA or stretched out over the spouse's lifetime.

Beginning in 2007, the tax laws will allow non-spouse beneficiaries to transfer inherited 401(k) or other company retirement plans directly into an inherited IRA. This allows beneficiaries to spread the distributions and the taxable income over several years, and--better yet--the inheritance, less required distributions, continues to appreciate tax-deferred.

Here's what you need to know:

In order for the non-spouse transfer to take place, the company plan must allow it. Check with the plan administrator to make sure the plan allows a direct transfer to an inherited IRA for a non-spouse beneficiary.

If you're a non-spouse beneficiary and you inherited a 401(k) or other company retirement plan in 2006, you may be able to defer the payout until 2007 to reap the benefits of the new pension law.

The law stipulates that the funds must be moved in a trustee-to-trustee transfer. This means that the beneficiary cannot receive a check and then deposit the check into an inherited IRA. Rather, instruct the plan to make the check payable to the trustee or custodian of the inherited IRA, making it a qualifying transfer.