Beware of Possible Estate Planning Issues Lurking in your 401(k) Plan

There are several reasons why rolling over your 401k into an IRA makes since. Estate planning is one of those reasons. And while you may think you have fully prepared by naming your beneficiaries on your 401k plan, there is still one very important issue that you need to consider.

All employer sponsored plans have very specific rules regarding how distributions will be paid in the event of a plan participant’s death. Often, when a plan participant dies the plan requires that the entire account balance be automatically distributed in a lump sum to the beneficiaries of the account. No big deal, right? Well, that depends on how you feel about paying taxes. The problem here is that when the lump sum distribution takes place it will be fully taxed at the ordinary income tax rate of your beneficiary, which depending on how much is inherited, could potentially push them into the highest marginal tax bracket of 37%. Ouch!

There is another wrinkle here. Unlike with the original plan participant, who has the option to open an IRA and deposit the lump sum distribution within sixty days to avoid the tax burden, the beneficiary of that plan does not have this option. Once a lump sum is distributed to a beneficiary of the plan, taxes are owed. There is however, a way to avoid having much of the wealth you intended to go to your heirs from being taxed all at once.

This is where one of the benefits of rolling your 401k to an IRA comes into play. Since many employer sponsored plans require a lump sum distribution, this eliminates the opportunity for a direct trustee-to-trustee transfer of the 401k to a Beneficiary IRA, which is required in order to avoid the ordinary income tax burden associated with the lump sum distribution. However, by having rolled your 401k plan over to an IRA you will have insured that your beneficiaries will have the option of the direct trustee-to-trustee transfer of the account. You will also have opened the door for more favorable options that will allow your beneficiary to spread the tax burden over many years, allowing the funds to continue growing and preserving the wealth you have left them.

To find out if your employer sponsored plan requires a lump sum distribution you can request a copy of the “Summary Plan Description” from the plan sponsor. This document will govern how the plan is administered and whether or not a lump sum distribution to your beneficiaries will be required.

If you are not sure if your employer sponsored plan requires a lump sum distribution to your beneficiaries please feel free to contact us anytime. It would be our pleasure to help.

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