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Now, if planning for your retirement has got you confused, you're not alone! There is no doubting the fact that many Americans have trouble distinguishing between the various flavors of retirement plans.

A few beneficiary basics: With an IRA, you can readily name any beneficiaries you want, including friends, family members, a trust or charity. For a 401(k) or other workplace plan, you must get your spouse's written permission to leave it to anyone else.  What if there's no beneficiary form on file? Heirs are at the mercy of the IRA custodian's default policy.  Most award an IRA first to a living spouse and then to the estate, but some send it straight to the estate. Few custodians will pass on an IRA directly to the kids without a beneficiary form.

There are also other issues to consider when setting up a plan, including providing for your spouse, maximizing the "stretch-out" distributions (a financial strategy to extend the tax advantages of an IRA), or keeping things even-steven - this often comes up when leaving assets to children and grandchildren, whether they are primary or contingent beneficiaries.

On the flip side - what do you do if you inherit IRA or 401k plan?  An inherited individual retirement account lies at the tricky three-way intersection of estate planning, financial planning and tax planning. Beneficiaries are advised to meet with their financial and legal advisors who can explain their options before cashing out the plan.   

Our first article focuses on tax issues when you inherit a 401k plan.  Mainly, how the plan is treated and types of payment distributions.  Interestingly however, inherited retirement funds are not always protected.  In our second article, we discuss the case of Clark v. Rameker which focused on the issue of protection of an inherited IRA from creditors.  The Supreme Court rendered an opinion stating why this was not the case.  The ruling more clearly defines the distinctions between inherited IRAs and IRAs set up for one's own retirement. 

Tax Issues When You Inherit a 401k

The death of a loved one inevitably causes distress.  However difficult it may be to focus on finances at such a time, there are certain things you'll need to know - especially for tax planning - if you are the beneficiary of that person's 401k plan.

How the 401k is Treated for Tax Purposes

When a person dies, his or her 401k becomes part of his or her taxable estate.  However, a beneficiary generally won't have to wait until probate is completed to receive the account balance.  You will need to pay income tax on the amount you receive (in addition to any estate tax owed) but there are different strategies you may be able to use to spread out or delay the tax burden, especially if you are the spouse.  There are other considerations, too, so be sure that you always work with a qualified tax expert before making any decisions.

All 401k Plans Are Not Created Equal

When looking at your options for receiving money from a 401k plan as a beneficiary, it is important to realize that each 401k plan has its own set of rules.  The IRS sets the outside limits of what plans may do, but a plan is allowed to be more restrictive than that general framework.  For example, the IRS may say it is perfectly acceptable for you to leave your 401k inheritance in the account for years without touching it (or paying taxes on it), but the plan rules may stipulate that you take it out sooner.  So, the first thing you should do is look at the plan document or summary plan description of the 401k plan to find out what rules will apply to your situation.  Rules may also differ depending on whether the person who died was your spouse, and whether he or she was already receiving periodic payments from the account.

The Most Likely Scenario: A Lump Sum Distribution

The most likely scenario is that you will need to take the money out of the account in one fell swoop. This is called a lump sum distribution.  Many plans will decide automatically to make a lump-sum distribution.  They do this for administrative reasons so they don't have to use resources to keep track of the account of an employee who is no longer there.  The lump sum you receive will be subject to local, state and federal income tax.  However, you may not have to pay the 10% early withdrawal tax even if you and/or the deceased person are under 59 � (the age at which account holders are allowed to start withdrawing money from their accounts without a penalty).

If you are the spouse, you are allowed to roll the money over into an IRA.  This way, you can avoid paying taxes until you make withdrawals from your IRA. You should consider a direct rollover - asking the plan sponsor (employer) to transfer the money directly to the financial institution that houses your IRA.  If you receive the check yourself, things become more complicated  -  the employer will be required to withhold and remit to the IRS 20% of the balance as a down payment on any taxes, and you will have to remember to deposit the check in your IRA within 60 days, otherwise the whole amount will be taxed.

If the plan contains company stock, you should check with a tax professional on possible strategies for reducing taxes when cashing it out.

Stretching Out the Payments

Any beneficiary, spouse or not, may be able to receive payments from the account over a period of years, spreading out the tax hit.  This depends on the rules of the particular plan and many aren't set up to allow periodic payments because of the administrative costs involved.  If the account holder was already receiving payments from the 401k plan when he or she died, you may be able to continue receiving payments over the same time period.  You may be able to speed up the payments and receive larger sums over a shorter time period.  However, you may not slow them down to receive smaller payments over a longer period of time.  You may also receive a lump sum distribution, or (if you are the spouse) roll the money over into an IRA.

If the 401k holder had not already set up a payment schedule before he or she died, you may still be able to set up your own payment schedule, either over five years or over your life expectancy, if the plan allows it.  If this is an option, you normally have until December 31 of the year after the person dies to decide whether you prefer the five-year option or the life-expectancy option.  If you don't specify a choice by then, the life expectancy will automatically be used for a spouse, and the five-year method will automatically be used for a non-spouse.  (Life expectancy figures and tables are available from the IRS at http://www.irs.gov.)

Under this option, if you are the spouse you have another decision to make.  You may either start receiving the payments by the end of the year following your spouse's death, or by the end of the year during which your spouse would have turned 70�.  If you are NOT the spouse, you will have to start receiving the payments by the end of the year following the person's death. In other words, you don't have the same possibilities as the spouse for postponing receipt of the taxable income.

As you can see, there are tax implications no matter what strategy you choose for receiving the 401k funds you inherit.  Therefore, you should strongly consider consulting your financial, tax or legal advisor who can help you determine what options you have for receiving the money, and the income tax consequences of the different options.  This isn't the kind of calculation you want to do yourself on the back of an envelope.

Supreme Court Finds Inherited IRAs Not Protected In Bankruptcy