Listen to Scott and Pat help a caller review the RMD distribution rules for non-spouse beneficiaries and weigh in on what might be the best course of action with investing the 401(k) dollars.
Scott Hanson: And let's start right off with Aaron, talking with Aaron. Aaron you're with Hanson McClain.
Aaron: Hey, how's it going?
Scott Hanson: Excellent, how are you Aaron?
Aaron: I'm great!
Scott Hanson: Thanks for being part of the program.
Aaron: Yeah, I like listening to you guys.
Scott Hanson: Thanks!
Aaron: And I value your opinion, which is, I'm trying to get second and even third opinions on what the wisest thing to do with a 401(k) that I inherited.
Scott Hanson: Okay.
Aaron: I'm 37, so I've started my own retirement in an IRA. But I've just learned, I didn't even realize that this inherited 401(k), I would have to take the minimum distributions when my father would've turned 70. He passed away last year and he was 64, so I'm thinking in 5 years I gotta start taking money out of that.
Scott Hanson: No no no no no.
Pat McClain: How large is this?
Aaron: It's a $116,000 right now.
Scott Hanson: And are you the full beneficiary on this?
Scott Hanson: Okay. So here's how the rules work. Spouses can have an unlimited transfer, but non-spouses, like children or anybody else, you can establish what's called a "beneficiary IRA".
Scott Hanson: So you could establish this through a brokerage firm, a mutual fund company, most firms will establish a beneficiary IRA. Now with this beneficiary IRA, there are rules regarding minimum distributions, and the rules are, it's not when he turns 70 and a half, the rule is, you must either take a distribution, start a distribution by December 31 following the year in which he passed away, which would be distribution by the end of this year, a distribution based upon your life expectancy...
Pat McClain: ... and the account balance.
Scott Hanson: If you fail to do that, the account must be completely distributed within five years.
Pat McClain: So that's the rules. It has nothing to do with his age.
Aaron: Okay. So I had some bad information there, then.
Pat McClain: That goes without saying. Now, the question we have otherwise is, do you have a 401k now?
Aaron: I have what, I talked to you guys before, what I'm doing is, I'm putting fringe benefits...It's my wages, it's not company match wages, but I am putting away anywhere from 10 to 15,000, roughly, a year in an IRA.
Pat McClain: Okay.
Aaron: Not a 401(k) because of the terms of how I work.
Pat McClain: Okay, so you have some sort of prevailing wage work.
Aaron: Right, right.
Pat McClain: All right, so what you can do is you can make a non-deductible IRA contribution with this money. Or deductible, depending upon on how that other benefit is being treated. But you can put a non-deductible IRA contribution in every year. So you need to start this distribution and I would actually make a non-deductible IRA contribution with this money. So you can't move it directly across but you can take the income and then make the non-deductible IRA contribution. Once you make the non-deductible IRA contribution, assuming you have no other IRAs, you can convert it to a Roth IRA the next day. That way it will grow tax-deferred to come out tax free.
Aaron: So the other thing I'm considering, and I'm just waiting to have enough people tell me it's a really bad idea to not do it, but I do provide a home for my mom.
Pat McClain: Okay.
Aaron: She's still alive but not able to work for herself. So I have a town home and a second town home, so I'm kind of invested in real estate. I could pass this IRA out and avoid the 10% early withdrawal fee, which I was also told. I could pay off one of those loans and just have her sit in there in a home that's paid for.
Pat McClain: So the problem with that is, if you cash this out all this year, you would actually take it all as income.
Scott Hanson: This year.
Pat McClain: This year, so it would drive you into a high tax bracket. So I'm not necessarily opposed to that idea, but I would probably stage it over five or seven years.
Aaron: Which is an option. I could take it all and then they could spread it out, right? Isn't that still...
Pat McClain: No...
Scott Hanson: Whenever you withdraw money from this account balance, and I was trying to look up an IRS table while we're talking but it...Anyway, if you look up an IRS life expectancy table, single life expectancy for a 37-year old, it'll give your life expectancy. Let's call it 45 years, let's call it 50 years to make it simple. This year, you must take out 1/50th, roughly 2% of the account balance. Next year, 1/49th. The following year, 1/48th. You gotta subtract by one, it's different than...
Pat McClain: So this year you would've taken out, you need to take out $2,500 to $3000.
Scott Hanson: That's your minimum. And when you take out, that's roughly two grand, that will be taxable to you. Now, I like the concept. One way to think about this is, "Why not just take out a monthly amount from this to pay the mortgage"?
Pat McClain: The loan on the house.
Scott Hanson: Yeah.
Aaron: Well, that would be one idea, but since I'm investing in real estate heavily and trying to get investment properties, I can only hold so many mortgages, so I was hoping I could kill two birds with one stone by paying one off and not having it on me.
Scott Hanson: Yeah, you could also use these dollars to buy a piece of property, $116,000...I wouldn't recommend it...
Pat McClain: Yeah I wouldn't do that because then your required minimum distributions become very complicated.
Pat McClain: So I'm not opposed to the idea of using these dollars to pay down the mortgage, I would just do it over a series of years, not all in one year. Might do it over three years, five years, seven years...
Scott Hanson: If you can swing it, and leave the money in this IRA growing tax-deferred, you'll only have to take out about two percent a year, you're going to find this thing is going to continue to grow. I've witnessed it personally when my wife's mother passed away, she had an inherited IRA of a smaller amount. And I've obviously dealt with a lot of clients but I've also had personal experience with it, and it's going to be growing faster than the distributions are and it's tax-deferred and it's just another... And it's good to be diversified! With real estate, but ideally, you look at most people with substantial assets, it's highly diversified, because things go through different cycles. So our advice is to maintain that beneficiary IRA as long as possible. But if you don't take a distribution, at least the minimum by the end of this year, Aaron, you gotta distribute the whole thing within five years. That's the thing you need to watch out for.