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One of the provisions that is available to the individual who inherits a 401(k) or other Qualified Retirement Plan (QRP) is the ability to convert the fund to a Roth IRA.
This gives the beneficiary of the original QRP the option of having all of the tax paid up front on the account, and then all growth in the account in the future is tax free, as with all Roth IRA accounts.
What’s a bit different about this kind of conversion is that, since it came from an inherited account, the beneficiary must take distribution of the account over his or her lifetime, according to the single life table. This means that, in order for this maneuver to be beneficial, the heir should be relatively young, such that there will be time for a lengthy growth period for the account – making the tax-free nature of the Roth account worthwhile.
A downside to this move is that the heir should be in a position to pay the tax on the account from other funds, otherwise the tax pulled from the account will drastically reduce the funds that can grow over time.
If the heir has an IRA of his or her own that could be converted, and there are only enough other funds for paying tax to enable the conversion of one account or the other, the IRA should be converted rather than the QRP. This is because the IRA has a much better chance for long-term growth than the inherited QRP due to the requirement for distribution of the account (as discussed above).
This is yet another reason that an individual might want to leave funds in a 401(k) plan rather than rolling it over to an IRA – since the heir does not have this Roth conversion option available if the money is in a traditional IRA. This option is only available for an inherited 401(k) or QRP.