Inherited 401(k)

Question:

I previously read your 2020 edition of Get Your Ducks in a Row. I believe I know the answer to my question based on what I read on page 88. I’m writing on behalf of my three adult nieces. Their mother (my sister) passed away suddenly in November 2023. She was predeceased by her husband who had also passed away suddenly in June 2023. At that time, my sister had her husband’s 401(k) transferred to her. Unfortunately, she never listed any beneficiaries on the account which is valued at about $581,000. I spoke to the Raytheon benefits department on a number of occasions, but the end result was that my nieces, who have all been appointed personal representatives for their mother’s estate, had no choice according to Raytheon except for the estate to take a total distribution of the 401(k) less the state income taxes.

My nieces received a net check made out to the estate for $542,501. They were informed that this is federal taxable income for the 2024 return. We were informed that there were no options for any type of rollover. It is my understanding that the estate is now responsible for the income taxes which, as you know, are quite high. I don’t know if they have any other options, but I don’t think so. My sister didn’t have a will. I’m retired and I actually prepare tax returns on a seasonal basis. I’ve never come across this before. Is there anything my nieces can do?

Response:

Unfortunately, I believe that Raytheon gave you and your nieces the wrong advice. Estates that inherit IRAs or 401(k) plan assets have up to five years to withdraw them and thus can take the income and pay the taxes over the five years, though this can mean keeping the estate open for those five years. In addition, they should also be able to transfer the IRAs to inherited IRAs, which would allow them to stretch the withdrawals over 10 years. See this article on this second possibility: https://www.wealthmanagement.com/estate-planning/ira-goes-estate-inherited-iras-individual-beneficiaries

It’s unlikely that you will be able to reverse the liquidation of the account, but perhaps you can force Raytheon to reimburse your nieces for the extra tax costs and lost tax-free investment income. That is probably a question of proof that they provided improper advice or unlawfully limited your nieces’ options. Of course, your nieces would have had to pay the taxes on these funds eventually. The extra cost would be if taking all the distributions in a single year pushes any of them into a higher tax bracket plus the benefit of tax-free earnings over five years. The latter might be hard to calculate since we don’t know what the investment earnings would have been, though it’s possible to come up with a low estimate based on current prevailing interest rates of approximately 5 percent.

In terms of minimizing the resulting taxes now, the funds should be distributed to your nieces. The estate will have to file a 1041 return reporting the income, but then will deduct the amount distributed to your nieces — the full amount. The income will then be taxed to your nieces rather than the estate, which will almost certainly result in lower taxes given that estates and trusts reach the top income 37% tax bracket at just $15,200 of income (in 2024).

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