What Happens When You Inherit a 401(k)

Starting in 2007, if you inherit a 401(k) or other qualified plan from someone other than your spouse, you may be able to transfer the balance directly into a traditional Individual Retirement Account (IRA).  This new rule gives you valuable opportunity to stretch the distribution (and tax) over your lifetime, while the investments continue to grow tax deferred. 

Previously, only spouses could roll over an inherited company plan to an IRA.  Everyone else usually ended up taking distributions in a lump sum or over a few years and paying substantial federal and state taxes as a result. 

To get the full benefit, it is important for children, grandchildren and other named beneficiaries to follow the rules strictly.  That means you must transfer the money directly into a properly titled inherited IRA that's maintained in the name of the deceased (for example, Robert Jones IRA (deceased Mar 1, 2007) for the benefit of Joseph Sandford, granddaughter).

Trying to roll the inherited money into your own IRA or cashing a distribution check made out to you could mean big trouble because you'd owe taxes on the entire amount.  So it is real important to be real careful when going down this path.  A company is not required to automatically transfer the money to an inherited IRA.  If it insists on issuing a check, make sure that the check is made out directly to the inherited IRA and not you.  Otherwise, by law that must withhold from the amount a 10% penalty, even if there is technically not one.