tax break for nonspouse beneficiaries
My friend "Rita," a victim of downsizing, was offered
a severance package from her employer. Her options: She could take
the entire amount as a lump-sum payout or receive it as biweekly
paychecks over a six-month period. Rita asked the human resources
person with whom she was dealing if she could divert a portion of
a lump-sum payout into her 401(k) plan on a pretax basis. The answer
she got: Yes, no problem.
But after she received her lump-sum check, she discovered
a problem: Her contribution hadn't been deducted. And when she followed
up with an HR manager about the matter, she was told that the federal
pension rules precluded a contribution to the 401(k)
plan in a lump-sum payout scenario. By the time she found out the
truth, it was too late to do anything about it.
That's the problem with a lot of decisions we have to make as we navigate our way through tax-related retirement moves. Even when we enlist the help of 401(k) plan administrators or human resources personnel, we may not get the right answers.
Unfortunately, some decisions, such as how we take
our retirement-plan distributions, can result in extremely negative
consequences. Once a misstep is made, there's no turning back. The
pension law gives us an opportunity to leave a lasting legacy
to our beneficiaries from our company retirement plans
-- including those who are not our spouses. Or it provides an opportunity
to make a financial foible. Take your pick.
Setting up the kids for a fall -- or windfall
Baby boomers often have complex family lives: second or even third
spouses, children from previous marriages, nonspouse domestic partners,
etc. The decision of how much money to leave and to whom to leave
it, in the event of a premature exit from this earthly plane, can
be very complicated.
For married folks with 401(k) plans,
the default beneficiary is normally the spouse. If you plan to leave
a portion of your 401(k) to anyone else (children from
a previous marriage, for example) your spouse has to sign off on
it and a notary has to witness the signature.
If a spouse inherits a 401(k) plan, he or she can
roll over the proceeds into an IRA with no tax consequences. A slam-dunk
move. But nonspouse beneficiaries generally have to take a distribution
within five years -- and sometimes immediately. Then they must pay
income taxes for the year they take the distribution and are not
entitled to the tax-deferral benefits of a sanctioned retirement
This all changes next year, due to a provision in
the new pension law. Beginning in 2007, nonspousal beneficiaries
can get the benefit of a "stretch" -- the ability to extend distributions
over their lifetimes. But H.R. folks who handle 401(k)
plans generally won't embrace the task of doling out the funds to
"They don't want the administrative headaches of keeping track of the beneficiaries of their ex-deceased employees as they travel around the world, paying them out for 50 years," says IRA tax expert Ed Slott. "They're just going to hit them with a check -- 'Goodbye! Good luck!' -- and get the account off the books."