While most of the time an inheritance of a Qualified Retirement Plan (QRP) such as a 401(k) or 403(b) can be distributed over the lifespan of the heir, such a stretch distribution is not required by the IRS. The only thing that the IRS requires of these plans is that they do not prescribe a benefit payout to an heir that is slower than the stretchout over the lifetime of the heir. This could sometimes mean that the plan requires a lump-sum payout of the plan benefits.
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Prior to 2006, this could really cause a problem, especially if you don’t need the funds at the time. In a good situation the plan might require a 5-year payout; for a rough go of it, they might push you to take the entire amount in a lump sum. Since PPA in 2006, there has been a direct rollover option available to beneficiaries of QRPs. You can set up an inherited IRA account (using the name of the decedent in the title, such as “John Jones, deceased, FBO Jane Jones”) and then perform a direct, trustee-to-trustee rollover into the IRA from the QRP.
This will satisfy the plan’s requirement for the lump-sum payout, while at the same time giving you the option of stretchout of the distributions over your lifetime. It is important to note that this rollover must be a direct, trustee-to-trustee rollover – the 60-day rollover cannot be used in this case!
One additional way to deal with such a payout requirement is to convert the QRP directly to an inherited Roth IRA account. Again, you need to ensure that the account is titled appropriately as mentioned above. But then you can convert the QRP to the Roth account.
This may be another good reason for leaving your retirement account in a 401(k) plan – since there is still no way that an inherited IRA may be converted to a Roth IRA account. In this case the heir has the flexibility to convert the funds rather than rolling them over.
A downside to this is that the inherited Roth IRA is required to distribute its funds to the heir over the heir’s lifetime – which is different from your normal Roth IRA. A standard, owned Roth IRA account does not have to distribute the account’s funds during the lifetime of the owner, but any inherited Roth IRA does. This is true whether the original account that was inherited was already a Roth IRA, or if it was converted from a QRP into the Roth.An IRA Owner's Manual or if you'd prefer the Kindle version (and let's face it, ALL the cool kids do!), you can find that at this Kindle version link.