Q: I’m 37 years old and my father recently passed away and left me his 401(k), which is currently worth about $115,000. I’ve got a good job and have been giving my mom cash each month for the last few years, and so I was thinking of just giving the 401(k) account to her (at the time of his death, my parents had been separated for some time). Any suggestions?
A: Inheriting a retirement account, such as a 401(k) or IRA, is, unfortunately, tricky business. The tax-deferred money that has accumulated in the plan will be taxable to the beneficiary who receives the proceeds. Plan correctly and you could enjoy decades of tax-deferred growth. Plan incorrectly, however, and even one small mistake could mean that you get slapped with a nasty tax bill.
Although you would like to simply give the account to your mother, you can’t unless she is also listed as a beneficiary. The 401(k) administrator won’t allow you to simply remove your name and replace it with your mother’s. And if you withdraw the entire account and give the funds to your mother, you will be the one responsible for the income taxes, which could result in a tax bill of tens of thousands of dollars.
As with any investment, it’s good to step back and reflect upon your primary objective. From what you’ve stated, it sounds like your main goal is to use these funds to help your mother with her day-to-day expenses, which seems like a worthy goal.
With that in mind, you’ll want to look at this 401(k) from two different angles: One, what can be done to minimize the taxes that will be triggered from withdrawals? And two, what’s the best way to invest these dollars?
One option is to simply have the 401(k) distributed in a lump sum and the money paid directly to you. While straightforward, the obvious problem with this approach is the income tax hit. If you have $115,000 paid directly to you, it would almost be the same as your income going up an extra $115,000. This, of course, could very well boost you into a higher income tax bracket and would be the worst way to handle this money.
Ideally, it would be good to keep as much of the cash inside the tax-deferred shell of the retirement plan as long as possible. Tax law will permit you to stretch out withdrawals for many years, but most employers don’t want the responsibility of maintaining the retirement accounts of their deceased employees, and will require that the account be closed within a year. (You’ll need to check with the plan administrator to see what options they provide to beneficiaries.)
Assuming the employer will not allow you to keep the 401(k) in place for the next several years, your best bet may be to have these funds transferred to what is known as a “beneficiary IRA”. With a beneficiary IRA, you simply have the 401(k) administer do what is known as a “trustee-to-trustee transfer,” where the funds are sent directly from the 401(k) to the beneficiary IRA without you ever taking possession of the money.
If done correctly, you will avoid all current taxes on the funds and you’ll have the flexibility of taking only what is needed to provide for your mother. There are some other requirements, such as the stipulation that you take out at least a minimum amount from the account each year, and other rules that are dependent upon whether or not your father had reached age 70½ prior to his death. I suggest you seek the advice of a good tax planner to fully understand all the various rules.
Once the funds are in the beneficiary IRA, you’ll want to invest these dollars with the objective of providing income to your mother. Even though you are relatively young, and it would appear that you have a long time horizon, your need for income from this account is immediate. Therefore, I would suggest you build a conservative portfolio that is comprised primarily of fixed income investments that are designed specifically for that purpose.
You can instruct the custodian of the beneficiary IRA to send you a check each month in whatever amount is necessary to cover what you’ve been sending your mother. Keep in mind that you will still be the one responsible for the income taxes due, so you’ll probably want to arrange to have some taxes withheld on the monthly distributions.
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @Scotthansoncfp