Don't drop the ball when handing off 401(k) funds

Lynn O'Shaughnessy
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Posted: Sep 19, 2006 12:00 AM

As I mentioned last week, millions of people don't enroll in 401(k) plans because it seems like a hassle. It doesn't matter that getting started would probably take less time than throwing a load of whites into the washing machine.

Curiously, this aversion to paperwork doesn't seem like much of a problem for departing workers, who are eager to get their hands on the money. But for former employees who appreciate the need to preserve their retirement cash, the paperwork hurdle once again turns into a sheer precipice.

In most cases, the best place for 401(k) cash for former employees is in an Individual Retirement Account. To establish one, you need to contact a financial institution, such as a mutual fund company or a brokerage firm, to obtain the documents necessary to complete the transfer.

Since most well-intentioned workers never get around to it, you may be wondering what's the harm of just keeping the money in the 401(k).

One of the many drawbacks to maintaining the status quo is that it can hurt loved ones, who ultimately inherit what's left in these workplace accounts.

What's the problem? Traditionally, only a husband or wife who inherits a 401(k) could take that money and roll it into his or her own IRA, where it could remain sheltered from taxes. Everyone else, including children and grandchildren, as well as same-sex partners, have always been prohibited from doing this.

For these beneficiaries, the lauded tax protection of a 401(k) becomes as permanent as wet toilet paper. That's because companies distribute the cash in lump sums to beneficiaries. Once these checks are issued, the tax protection vanishes and income taxes on the full amount is owed. Ouch.

Beginning in 2007, however, people who inherit a 401(k), 403(b) or a 457 plan won't get the shaft. Thanks to the Pension Protection Act of 2006, anybody who inherits one of these accounts will be able to move that money into an IRA. Although Congress has made it easier to keep the tax benefits of a 401(k) alive for beneficiaries who aren't spouses, the process still isn't idiot-proof. If you inherit a workplace plan, you need to be careful about the handoff.

When a 401(k) is rolled into an inherited IRA, for instance, it's important to title the account correctly. For instance, let's suppose that John Smith inherits a 401(k) from Mary Smith, his mother. If he decides to preserve this money in an IRA, the new account should be written this way: Mary Smith IRA (deceased Sept. 1, 2007) f/b/o (for the benefit of) John Smith.

Getting the title right on an IRA account might seem silly to everyone but a stenographer. The IRS, however, isn't going to be amused when it tells you that you owe tax on a botched IRA transfer. Suppose, for instance, that a son deposited his mom's $100,000 401(k) into his own IRA instead of a new, inherited IRA that's correctly titled. That mistake would cost him dearly. If he was in the 35 percent tax bracket and paid 8 percent in state taxes, he'd owe a total of $43,000 in taxes for that error. And, of course, the cash that's left couldn't remain in the tax cocoon.

Unfortunately, there are other ways for an inherited 401(k) to self-destruct.

And once again the transgressions might seem on par with a kid not sending a thank-you to Grandma for a birthday gift. For example, the IRS can grind your inherited windfall into pulp if the workplace cuts a check to a son or daughter (or any beneficiary besides a spouse) to empty the workplace account. Even if the child deposits the check into a properly titled IRA, the IRA could implode.

That's because only spouses can complete a rollover. Everybody else must rely on a trustee-to-trustee transfer.

With a trustee-to-trustee transfer, you will never have the 401(k) proceeds arrive in your mailbox. Instead, the workplace must mail the assets directly to the financial institution where the IRA account is waiting.

Some companies, however, can't or won't get involved in making sure that the correct transfer is completed. There is a way, however, to sidestep pigheaded companies. If the workplace insists on sending a beneficiary a check, he or she can request that it be properly titled so that the retirement account is protected. The company would have to issue the check in a way that would ensure that it's deposited only in the inherited IRA account.

Using the example above, here is what it would look like: "National Bank as trustee of Mary Smith IRA (deceased Sept. 1, 2007) f/b/o John Smith."

The only people who don't have to worry about following these picayune rules are spouses. An individual who inherits a spouse's 401(k) or IRA can move the money into his or her own IRA.

And here's one final warning: If a worker is married, the beneficiary of his or her 401(k) legally must be the spouse. If you've designated children from a first marriage on your beneficiary form, your wish will be valid only if your current spouse signs a waiver relinquishing his or her rights to the cash.