Implementing an acquired 401(k)

Key Points

Q. I was just named the beneficiary of a 401(k). Please explain what options I have.

A. Now that you have inherited a 401(k) plan account, you have four basic options that depend on many factors, including the terms of the 401(k) plan and your relationship to the deceased 401(k) plan participant:

Although you can take an immediate cash distribution, it seems unlikely that you, as a practicing ophthalmologist, would need the funds immediately. If taking a lump-sum distribution from the 401(k) plan is a viable alternative for you, however, then you will have to pay ordinary income tax on the distribution (except for the amount of any after-tax contributions or qualified Roth distributions, if any). Special tax rules may apply if the plan participant was born before Jan. 2, 1936, so please consult a tax professional for details. A lump sum might be attractive if you are entitled to a distribution of employer stock. You may be able to pay ordinary income tax on just the participant's basis in the stock and defer tax on the appreciation (called "net unrealized appreciation") until you sell the stock in the future at capital gain rates.

If you're like most beneficiaries, your goal will be to stretch payments out as long as possible, taking full advantage of the tax deferral offered by retirement plans. That means either leaving the assets in the 401(k) plan or rolling them over to an IRA. For most people, leaving the funds in the 401(k) plan isn't the best choice, for two reasons. First, the investment alternatives available to you in a 401(k) plan are limited to those selected by the employer. Second, the distribution options offered by a 401(k) plan typically aren't as flexible as those available in an IRA. In fact, many 401(k) plans require beneficiaries to take distributions shortly after the participant's death.

Unless the 401(k) plan offers a unique investment alternative, rolling the 401(k) assets over to an IRA usually will be your best choice. Most IRAs offer virtually limitless investment options. And when it comes time to take distributions from the plan, IRAs offer the most flexible payment provisions. But before deciding on a rollover, make sure you understand any fees and expenses that may apply. If you are a surviving spouse, then you will have to decide between rolling over the funds to your own IRA or to an IRA that you establish in the participant's name, specifying yourself as the beneficiary (this is referred to as an "inherited IRA"). Which should you choose? In most cases, you would be better off rolling over the funds to your own IRA. Rolling over the funds to an inherited IRA typically is appropriate only if you're not yet 59½ years old and you think you'll need the funds before you reach that age. That's because distributions from an inherited IRA aren't subject to the 10% early distribution penalty tax. (In contrast, distributions from your own IRA before age 59 ½ are subject to the 10% penalty tax unless an exception applies.)