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The Pension Protection Act was recently
passed by Congress and signed into law. It is “the most sweeping
reform of America's pension laws in over 30 years.” Whether you’re
retired or still laboring to build your nest egg, the Pension
Protection Act (PPA) will affect you. Read on to find out how.
For those still working, the PPA forces a company to fully fund its
defined-benefit pension obligations, meaning a company can’t promise
benefits they can’t pay. While this will make existing pension
programs stronger, it will also decrease the number of companies
offering pensions to their employees.
The PPA also makes permanent the increased contribution limits that
were passed in 2001. That means that employees will continue to be
able to set aside greater amounts in their 401(k) and their IRA. It
means that those over 50 years old will continue to have a
‘catch-up’ provision that increases their contribution limits.
One change in particular, though, has the potential to save families
tens, if not hundreds, of thousands of dollars. It is the provision
that will allow a non-spouse beneficiary to ‘roll’ money out of a
401(k) and into an IRA. Let me explain.
Recently, I was contacted by a reader. He was inheriting the money
out of his deceased father’s 401(k). In the past, this would mean
that he would have to take all the money out and pay taxes on it.
When money comes out of a 401(k) it is taxed just like your salary
or wages. If there was $500,000 in the 401(k), he was going to be
taxed as if he had a job making over $500,000 that year. He would
end up losing as much as 1/3 of it to taxes. Imagine finding out you
were going to inherit $500,000 only to learn that over $150,000 of
it would be lost to income taxes!
If the reader was inheriting that money from his father’s IRA
instead, he wouldn’t have to pay any of those taxes right away. When
someone dies, money from his/her IRA can be rolled to an ‘inherited
IRA’ and continue to grow tax-deferred. This is referred to as
‘stretching’ the IRA.
If the person inheriting the IRA was in their 30’s, this ability
could turn a $50,000 IRA into one worth several million dollars over
their lifetime. The impact of this cannot be understated. Yet it
couldn’t be done with a 401(k) unless your spouse was the
beneficiary. Thanks to the new Pension Protection Act, now you can!
There are some specific rules that must be followed. First, the
distribution must occur after January 1, 2007. If the company is
willing to wait until after that date, my reader will be able to
roll his dad’s 401(k) money to an IRA and avoid the taxes.
Second, the money can’t be added to an existing IRA. You have to set
up a new inherited IRA. The inherited IRA must be in the same name
and have the same beneficiaries as the 401(k) account that is being
rolled into it.
Third, this can only be done if the beneficiary of the 401(k) is a
real person. For instance, it is an option if your children are the
beneficiaries, but isn’t an option if your ‘estate’ or a trust is
the beneficiary because an ‘estate’ is not a real person.
Fourth, the transfer must be done by direct rollover. This means
that the money must move from the 401(k) directly into an IRA. So if
the company wants to send a check to you, it must NOT be made
payable to you. It should be payable to the inherited IRA.
Unfortunately, banks and other 401(k) providers aren’t up to date on
these new provisions, so don’t be discouraged if they tell you it
can’t be done. Because just having one detail out of place can
negate an inherited IRA, consult your CPA to make sure the details
are handled correctly.
For those who have existing 401(k)s, verify who your beneficiaries
are and make any necessary changes. Choose actual people, instead of
trusts or estates. And in your important papers, make sure to inform
your heirs they have the option to stretch that money in an
inherited IRA.
I’ll personally respond to your questions, free of charge. Go to
http://www.guardingyourwealth.com and click on ‘Ask Jeff’.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie provides personal,
private money management services to clients nationwide. |
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