How to Convert an Inherited Company
401(k) Plan to a Roth IRA
©
Shane Flait (2012)
The Pension Protection Act of 2006 (PPA)
permits you to convert your company
retirement plan assets, including a
401(k), 403(b), and 457 plans, directly
to a Roth IRA. Of course, you must pay
the income tax on the conversion of a
deductible company plan to the Roth IRA.
You can do this if you’re the owner, the
owner’s spousal beneficiary or the
owner’s non-spousal beneficiary.
An alternative for the owner or his
spousal beneficiary is to first make a
tax-free conversion to a Traditional IRA
from the deductible company plan, and
then later convert that Traditional IRA
to a Roth IRA. But a non-spousal
beneficiary can’t do that.
A non-spousal beneficiary of a company
plan can only transfer the plan money
into an ‘inherited IRA’ – either the
traditional IRA or a Roth IRA. But he
can’t later convert an inherited
traditional IRA into a Roth IRA. So if
he wants that money to go into a Roth
IRA, he’s got to make that decision
upfront when converting the inherited
company plan.
No income restrictions rollover to a
Roth IRA
Whether converting the plan money to a
traditional or Roth IRA, he must do a
direct rollover (i.e. trustee to
trustee) from the company to his
designated ‘beneficiary’ IRA. Be sure
to check that your company plan allows
for such a transfer.
After 2010, there are no income
restrictions on converting to a Roth IRA
(before he had to have an adjusted
growth income (AGI) of under $100,000).
But you need to have the money
to pay the taxes on the conversion up
front.
RMDs from Roth only for nonspousal
beneficiaries
One of the benefits of a Roth IRA is
that the original owner or his spousal
beneficiary doesn’t have to make minimum
required distributions from his Roth
after turning 70½ - as is necessary from
Traditional (deductible) IRAs. But,
that’s not the case for a nonspousal
beneficiary.
The nonspousal beneficiary is required
to make minimum required distributions (RMDs)
beginning
the year after the death of the owner.
These distributions aren’t taxable and
are not assessed penalties – regardless
of age of beneficiary. The amount of the
RMD is based on the initial life
expectancy of the beneficiary when the
RMDs begin – with that life expectancy
reduced by ‘1’ each year thereafter.
But that’s not such a problem if he’s
still quite young…
The benefit of a Roth IRA inherited by a
young nonspouse beneficiary
If the non-spouse beneficiary has the
ability to pay the taxes for the Roth
conversion and is still young, the
conversion can be advantageous. Let’s
say he’s 33 years old; The IRS Table I
for his life expectancy gives him 50
remaining years. With such a long time
left, his new Roth IRA can grow
considerably because of the relatively
small percentage (starting at 2%) of his
holding must be withdrawn in the early
years as his required MRD. That small
MRD will not detract much from his IRA
holding if it grows at 5% or more. It
should increase for many years before
the RMDs deplete it.
In fact, if the initial Roth IRA
investment was $10,000 and grew at a 7%
growth rate, it would peak at about
$35,000 after holding it for 35 years
despite having to withdraw those yearly
– and slowly increasing - RMDs. Of
course the RMDs would necessarily
deplete the Roth IRA at 50 years – the
projected life expectancy when he was
33. (see the figure)
The key tax benefits of the Roth IRA are
that the money grows tax free (not
simply tax-deferred) and whatever you
take out of it is also tax free.
So it will never burden you with taxes
no matter how high your income becomes.
You might even use some of the Roth IRA
as a tax free source to pay for the
initial tax on its conversion.
Shane Flait is a writer and educator.
See more at
www.EasyRetirementKnowHow.com
