Q.: I am single and just learned I inherited a 401(k) and an IRA from my sister. Can these be rolled over or converted to a Roth IRA?
— Al in Boise
A.: My condolences on the loss of your sister, Al.
There are a large number of options and restrictions when inheriting a 401(k), IRA or Roth IRA but here are some highlights.
Upon one’s death, the permitted transfers are:
1. Deceased’s pretax 401(k) to Inherited IRA
2. Deceased’s pretax 401(k) converted to Inherited Roth IRA
3. Deceased’s Roth 401(k) to Inherited Roth IRA
4. Deceased’s after-tax contributions in 401(k) to Inherited Roth IRA
5. Deceased’s IRA to Inherited IRA
6. Deceased’s Roth IRA to Inherited Roth IRA
Note that none of the options include rolling funds into any of your existing personal 401(k), IRA or Roth IRA accounts. The list includes only “Inherited” accounts as possible destinations. This is because only spouses can roll a deceased’s retirement accounts into their own accounts.
Inherited accounts can utilize “stretch” provisions in the tax law. When a stretch is not employed, generally the account must be fully distributed within five years. The stretch provisions are so named because they allow you to be subject to a Required Minimum Distribution based upon your age and thus stretch out distributions over more than five years.
Some 401(k) plans allow the deceased’s assets to stay in the plan as an inherited account and include stretch provisions, but many do not. When no stretch is available, the entire plan balance must be distributed within five years, rolled over to an eligible inherited account, or converted to an Inherited Roth IRA.
You can see that the items 1-4 relating to 401(k) balances offer different options based upon the nature of the funds in the 401(k).
You may also notice that I did not list an option to convert a deceased’s IRA to an Inherited Roth IRA. This type of conversion is not allowed under the law IRC Section 408(d)(3)(C). So, once you roll 401(k) money into an Inherited IRA, those funds are no longer convertible to a Roth IRA.
Other than item 2, none of the transfers trigger any taxes if done via so-called “direct rollovers” or “trustee to trustee” transfers. In a direct rollover, the check from the 401(k) is made payable to the Inherited account for your benefit, not to you as an individual.
This is important because IRC Section 408(d)(3)(C) is clear. If the 401(k) money is paid to you, that distribution is not eligible for any rollover treatment. You’ll owe tax on the 401(k) balance that was paid to you.
Item 2 causes the amount converted to the Inherited Roth IRA to be recognized as taxable income. This is the only situation in which retirement funds can be converted after death. The five-year rule regarding the 10% penalty on conversions does not apply even if the beneficiary is under 59½. However, the five-year rule regarding the taxation of earnings applies regardless of the beneficiary’s age.
Because Inherited Roth IRAs are subject to Required Minimum Distributions but personal Roth IRAs are not, it is generally better to convert your personal IRA rather than converting a deceased’s 401(k) into an Inherited Roth IRA.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.