If the deceased has named their estate as the beneficiary of their 401(k) and has corresponding instructions in their last will and testament as to whom should receive the 401(k) plan proceeds, the executor should notify the 401(k) plan administrator that a trustee to trustee transfer will be made to the the trustee that the beneficiary named in the last will testament selects. The executor should avoid receiving the funds in the estate account since it will not be eligible for a IRA rollover unless the named heir is the deceased's spouse. The plan funds must be transferred from the 401k plan administrator via a u201ctrustee to trustee transferu201d to defer taxation on the funds. If the estate 401k plan beneficiary is not concerned about income tax consequences on the funds, then the funds can be disbursed to the estate and then to the beneficiary or directly to the beneficiary from the 401(k) plan.When a qualified plan participant dies without naming a beneficiary, or they have named their estate as beneficiary, the executor of their estate must use caution to prevent full taxation while maneuvering these funds through the estate settlement process. This document will provide guidance to the executor for reducing income tax consequences to the estate and heirs. Definitions are provided for italicized terms.A Worst Case ScenarioIf the executor requests that qualified funds be disbursed to the deceasedu2019s estate, the estate is 100% taxed on the taxable portion of the distribution. (Neither After-tax contributions nor Roth IRA funds are taxable upon distribution.)Taxable qualified retirement distributions made after death are considered u201cIncome in Respect of Decedent u201c hereinafter called (IRD) and is taxable to the recipient as such. Code Sec. 408(d) and Code Sec. 72 (Rev. Rul. 92-47, 1992-1 CB 198). If the estate receives IRD, in this case in the form of IRA proceeds, and distributes the IRA proceeds to the heirs, it can claim a tax deduction for the amount of the distribution. (See instructions for Schedule B Form 1041). Reporting income to the heirs is performed by issuing a K-1.As a quick side bar, the estate can also take an income tax deduction for administrations expenses, if the executor files a statement waiving the right to deduct administration expenses on the Estate Tax Return, Form 706. An executor will file this statement on the estate income tax return, Form 1041. An executor is required to file Form 706 when the estate is valued in excess of $5.4 million.You should also know, that an income tax deduction cannot be taken for funeral, medical and dental expenses.Since estate income tax brackets escalate faster than personal tax brackets, IRC distributions to heirs normally results in lower taxation of the funds. Also, if an estate has multiple heirs, resulting in the IRC being distributed to a number of recipients, the taxable income is spread out among those heirs.Example:Okay, so now if the deceased plan participant had one million dollars in his qualified retirement plan, we have one million dollars of taxable income that is either taxable to the estate or taxable to the heirs receiving the funds. So, somebody is thinking, u201cWhy donu2019t the heirs just roll over these funds into a Beneficiary IRA? The answer is painful.The only heir that is eligible for an IRA Rollover is the deceasedu2019s spouse. A non-spouse is prohibited from rolling over qualified retirement funds (PLR 2005-13032). This means that if a non-spouse receives a check from the estate, or, for that matter, receives a check directly from the plan administrator or plan custodian, they will be taxed on the distribution in the year paid without remedy. To put it plainly, you cannot set up a beneficiary IRA with a check from the estate, nor can you set up a beneficiary IRA with a personal check. A beneficiary IRA must be expedited as a Trustee-to-Trustee transfer from one qualified plan custodian directly to another plan custodian. Code Section 408(d)(3)(C). If a beneficiary IRA is set up any other way besides a Trustee-to-Trustee transfer or re-titling it at the original custodian, it is a rollover which is prohibited by tax law unless you are the spouse of the deceased.Just one more point on this matter. If you manage to set up a beneficiary IRA with a personal check because a financial institution, such as an insurance company takes your check along with an application for an annuity designated as a beneficiary IRA, tax law is clear that the beneficiary IRA will not be recognized as such by the Internal Revenue Service. If this happens, here are my concerns:1. You, your agent or financial advisor believe that the funds have been successfully placed in a Beneficiary IRA just because the annuity application and the issued annuity clearly states it is a beneficiary IRA.2. Consequently, you believe that you have avoided the taxation on these funds until later distribution, when, in fact, they are fully taxable in the year these funds were disbursed to you.3. You also mistakenly believe that you can receive distributions from the beneficiary IRA over the course of five years, your life expectancy, or the deceasedu2019s life expectancy. In fact, since these funds are not recognizedas a beneficiary IRA by the IRS, you have indeed purchased a non-qualified annuity, that is subject to 10% non-deductible tax penalties on all interest that is paid to you under the age of 59 u00bd.4. Also, when the IRS sends you a letter requesting a past due tax payment on the initial distribution from the estate or the IRA custodian, you will likely be subject to substantial surrender charges for premature surrender of the annuity.The consequences are:1. You will pay the back taxes that were due for the year of disbursement on the qualified plan distribution.2. You will pay penalties and interest for underpayment of income taxes.3. If you must withdraw funds from the non-qualified annuity that you thought was a beneficiary IRA, and if you are under the age of 59 u00bd, you will be accessed a 10% penalty; plus, payment annuity surrender charges that could be high enough to cause you a nervous breakdown.Can this Tax Tragedy be Avoided with Tax Strategy?The short answer is, u201cMaybe.u201d To successfully postpone taxation on qualified funds that have no beneficiary, the executor should make a request to the deceasedu2019s qualified plan custodian to continue to hold the funds until further notice. Be aware that a company qualified plan custodian will have guidelines that may restrict them from honoring a request.The plan custodian may also have restrictions as to the disbursement of qualified funds when there is no named beneficiary or when the estate is beneficiary. If a beneficiary has not been named, you will want to ask if they have a default beneficiary. If so, you may have options that allow you to stretch the taxation of the IRA over many years using qualified disclaimers, etc.Once the executor has decided it is time to make distributions of the qualified retirement funds, he/she should consult with the deceasedu2019s qualified administrator / custodian to ask their procedure for the disbursement of the funds. In all likelihood, the executor will need to consult with the heirs who are to receive the qualified funds as to whom they prefer to have as their Beneficiary IRA custodian. It, of course, may be a bank, a brokerage firm, an insurance company or another financial institution. In any event, these firms will have Beneficiary IRA trustee-to trustee transfer forms that should be completed. The estateu2019s personal representative should then send the trustee-to-trustee forms to the deceased qualified plan administrator with written instructions as to the percentage or amounts that should be disbursed to the beneficiary IRAu2019s custodian. By using this method of disbursement, the executor has assured that the funds remain in a qualified plan and the non-spouse beneficiary will not be taxed on the funds until they are disbursed to him/her from their beneficiary IRA.As stated earlier, the deceasedu2019s plan custodian will have plan provisions that dictate their disbursement criteria. So they may require that a deceased plan participantu2019s estate receive funds when no beneficiary is named or when the estate is the beneficiary. If so, the estate, if allowed, should have the qualified retirement funds of the deceased, trustee to trustee transferred to an IRA that is titled after this example or something similar to it, u201cAlice Doe f/b/o Estate of Joe Smith,u201d or u201cAlice Doe, Executor of the estate of Joe Smith, as beneficiary of Joe Smith.u201d To postpone taxation, the funds should stay in this account until the estateu2019s personal representative is ready to process a trustee-to-trustee transfer to an heiru2019s beneficiary IRA custodian.When there is no beneficiary and the executor has successfully helped an heir or heirs of the estate set up a beneficiary IRA by having the deceased qualified plan administrator execute a trustee-to-trustee transfer to the beneficiary IRA custodian, the beneficiary then must use the 5-Year Rule for taking distributions from the beneficiary IRA . The beneficiary is not a u201cDesignated Beneficiaryu201d if he or she was not named as a beneficiary by the deceased; consequently, the beneficiary is not entitled to take distributions over the course of his /her life expectancy or the deceasedu2019s IRA holderu2019s life expectancy.The 5-Year Rule applies when the IRA holder dies before age 70 1/2 and the IRA holder has no designated beneficiaries at the time of death. The minimum required distribution for a beneficiary IRA under the 5-Year Rule is: u201cAll benefits must be distributed no later than December 31, of the year that contains the fifth anniversary of the participantu2019s death. Reg. u00a7 1.401(a)(9)-3, A-2.Consequently, by using trustee-to trustee transfers of qualified retirement accounts from the deceased qualified planu2019s custodian to the estate beneficiary IRA custodian or to preferred beneficiary IRA custodians, the holder of the beneficiary IRA has five tax years to liquidate the IRA rather than experiencing full taxation on the funds in the year received.Titling the Beneficiary IRAA title example of an individual beneficiary IRA is, u201cJoe Smith, deceased, f/b/o Jane Doe.u201dA title example of an IRA that is payable to the deceased qualified plan participantu2019s estate is, u201cAlice Doe, f/b/o Estate of Joe Smith,u201d or u201c, Alice Doe, Executor of the estate of Joe Smith as beneficiary of Joe Smith.u201dA title example for a Trust that is beneficiary is, u201cJoe Smith, f/b/o Joe Smith Testamentary Trust,u201d or Alice Doe of the Joe Smith Revocable Trust, as beneficiary of Joe Smith.u201dDisclaimer:This report does not cover all the possible contingencies regarding beneficiary IRAs and the tax implications, on the estate, its heirs, and beneficiaries. My hope is that it informs you well enough for you to know that all concerned needs to consult qualified estate and income tax professionals who have expertise specific to this matter.
