Roth 401k Rollover for Non-Spouse Beneficiary

Should a Non-spousal Beneficiary Perform Roth 401k rollover?

The Pension Security Act of 2006 (PPA) currently permits you to convert your company retirement plan assets, including a new 401(k), 403(b), and 457 accounts, directly to a Roth IRA.The spouse of a deceased account holder also has that option. Upon death of the account holder, the spouse in fact has the flexibility to first do a tax free rollover to a traditional IRA. At a later time, should the spouse find it advantageous, the spouse could decide to convert that IRA account to a Roth IRA (and pay the tax due).

A non-spouse beneficiary does not have the above flexibility. Upon inheritance, he must make a one time choice between having the funds got to a traditional IRA (a tax free transfer) or to a Roth IRA (a taxable transfer) and gain tax free benefits for life.

A non-spousal beneficiary of a business retirement plan (e.g. 401k) can only transfer the inherited funds into an 'inherited IRA' : either the traditional IRA or perhaps a Roth IRA. But he can't afterwards convert an inherited pre-tax IRA into a Roth 401k rollover IRA. Therefore he wants that money to enter a Roth account, he's got to choose the Roth 401k rollover at the time of inheritance.

Restrictions with a Non-spouse Roth 401k rollover

Whether converting the account to a traditional or even Roth IRA, he must do an IRA direct rollover (i.e. trustee to trustee) from the company to his or her designated 'beneficiary' IRA. Unlike others who can take possession of retirement funds and transport them between retirement plan custodians, a non-spouse beneficiary may never take possession of the retirement funds. If he does, the money is immediately taxable and there is no recourse.

The non-spouse inheritor has the same conversion constraints for a Roth 401k rollover as the owner did such as penalties pertaining to withdrawals in the first 5 years. Also, like the owner or even spousal beneficiary, he must have the money to pay for the taxes on the roth401krollover. These funds should not be taken from the IRA or the idea of converting pre-tax funds to post-tax funds is not advantageous.

Lastly -and unlike the owner or even a spousal beneficiary - he's required to take an annual minimum IRA distribution starting the year after the death of the owner. If the distributions are from a traditional IRA, these distributions are taxable but exempt form any age requirement (i.e. the age 59 1/2 IRA penalty does not apply). But the distribution from the Roth 401k rollover is based on the initial life expectancy of the beneficiary and will not be taxed.

Why should the beneficiary choose the Roth 401k Rollover?

If the non-spouse beneficiary has the ability to pay the taxes for the Roth 401k rollover and is young, the selection can be advantageous. If he's really young - say thirty-three - with an IRS life expectancy of fifty years, his Roth IRA can potentially grow considerably because of the relatively small (starting at 2%) annual distributions required. The table below shows the potential growth of the account for such a beneficiary.

Two other benefits of performing a Roth 401k rollover are:
• The financial resources are available free of tax, perhaps to pay back whatever had been borrowed to pay the in advance taxes.
• The Roth is a tax free source of money which will never be be subject to potentially rising income tax rates - as a Traditional IRA would be.