Giving 401(k) to someone other than spouse means huge tax break

Congress has enacted a huge new tax break for people who inherit a 401(k) account from someone other than a spouse.

This is great news for anyone who wants to leave a 401(k) to a child, grandchild, domestic partner, or other person other than a spouse.

The old rule was a spouse by inheriting a 401(k) could roll the account over into an IRA.  The spouse could then take only the minimum required distributions from the IRA, and allow the remainder of the assets to grow tax-free.  The spouse could even leave the IRA to someone else, extending the tax breaks even further.

However, if you left a 401(k) to someone other than a spouse, this wasn’t true.  Most of the time, the 401(k) plan would require the beneficiary to receive all the assets within five years.  Since the money couldn’t be rolled over, the beneficiary would have to pay tax on the entire sum right away and couldn’t “stretch out” the tax benefits over many years.

Under the new law, however, non-spouses can now move inherited 401(k) money into an IRA.

However, you have to be careful.  The 401(k) assets must be moved into an inherited IRA, meaning an IRA that the beneficiary inherited from the deceased.  The assets cannot be moved into the beneficiary’s own IRA, or the tax benefits are lost.

In addition, the money must go from the 401(k) to the inherited IRA by means of a “trustee-to-trustee transfer.”  This means the money must go from one account directly to the other without going through the beneficiary.  If the beneficiary receives the money from the 401(k) and then tries to roll it over into the inherited IRA, it won’t work – and all the tax benefits will be lost.

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