Should a Non-spousal Beneficiary Perform a 401k Rollover to Roth IRA?

Prior to the 2006 Pension Protection Act, if you wanted to turn your company retirement plans, including a 401(k), 403(b), and 457 plans, directly to a new Roth IRA, you couldn't do it. Your 401k rollover to Roth IRA was more convoluted. You first had to convert the company account into a traditional IRA ( a tax free rollover) and then convert the traditional IRA into a a Roth IRA (a taxable event). Now, IRS has realized the extra step and either the owner or even his spousal beneficiary do a 401k rollover directly to a Roth IRA. However, most are reluctant to do this because of the tax that must be paid on the converted dollars. So it is common to still see people do the two step process--first convert a company account into a traditional IRA (which has no tax assessment) and then, maybe several years later, convert to a Roth IRA.

A non-spouse IRA beneficiary of a company retirement plan does not have this flexibility. A non-spouse beneficiary may only decide once, at the time of the rollover--will it be into a traditional IRA or Roth IRA. What are his or her options and what does he need to do? Lets look at 401k rollover to Roth IRA. The benefits of a 401k rollover to IRA are potentially great.

A non-spousal successor of a retirement plan is only able to transfer the plan money in to an 'inherited IRA' - either the standard IRA or a Roth IRA. Yet he can't later convert an inherited traditional IRA in to a Roth IRA. So if he would like that money to go into a Roth account, he's got to make that decision at the time he elects the 401k rollover to Roth IRA. If the administrator of the 401k plan does not force him to take the money (and many do within 12 months after the death of the account owner), he can delay making the decision.

Restrictions with a Non-spousal 401k rollover to Roth IRA

No matter whether converting the money to a traditional or Roth IRA, he must do a direct IRA rollover ( i.e. trustee to trustee) from the business to his designated 'beneficiary' Individual retirement account. The non-spouse beneficiary may never possess the funds as that would be deemed a distribution which could not be rolled over.

The non-spousal beneficiary has the identical conversion restrictions for a 401k rollover to Roth IRA as the proprietor did such as penalties regarding withdrawals in the first few years. Also, like the owner as well as spousal beneficiary, he must have the money to pay for the taxes on the 401k rollover to Roth IRA.

Lastly -and unlike the owner or even a spousal beneficiary - he's required to perform required minimum distributions (RMDs) starting the year after the death with the owner. These distributions aren't taxed and are not assessed fines - regardless of age of successor. Instructions are in IRS Publication 590.

Why Convert 401k rollover Roth IRA?

If the non-spouse inheritor has the ability to pay the taxes for the 401k rollover to Roth IRA and is relatively young, the conversion can be quite lucrative. If he's quite young - say age 33 - with the IRS Table I life expectancy of 50 years, his Roth Individual retirement account can potentially grow considerably due to relatively small required minimum distributions (starting at less than 2% of the account value).

Other benefits of completing a 401k rollover to Roth IRA are:

The distributions form the Roth IRA are available free of tax -- perhaps to pay back whatever has been borrowed to pay the advance taxes.
Because the distributions are tax free, they are immune to increases in federal tax rates which are almost a certainty to balance the federal deficit