Q: A friend of mine recently passed away and left me as his beneficiary for his life insurance and 401(k). What are the tax consequences if I accept these funds? If I decide to give these funds to his family, will I have to pay any tax?
A: Inheritances are excluded from the definition of income. So the receipt of the life insurance proceeds will not cause you to pay any tax. The 401(k) plan assets will be a bit different.
There are certain types of assets that create income during the life of an individual, but which are not taxed based on the accounting rules of the tax law. Funds placed in a 401(k) plan, and the earnings on those funds, are one example of such an asset.
The tax law refers to inherited funds in a Section 401(k) plan as “income in respect of a decedent,” or IRD for short. When IRD assets are inherited, there is no immediate tax due.
As payments are received, the party who inherited the IRD funds is taxed the same way that the decedent would have been taxed had he survived to receive the payments.
The purpose of the IRD rules is to ensure that someone pays tax on the payments. IRD payments are different from inheritance assets in general, because the income was realized during the decedent’s life; it was just not taxed because of the special rules of the tax law.
If your friend had no after-tax contributions to the 401(k), you will be taxed on any payments that you receive from the plan. You need to consult the plan to determine your distribution options.
For the second part of your question, the possible transfer of the inheritance to your friend’s family, the answer depends on how that is done.
If you first inherit the funds and then make a gift to the family, you may have to file a gift tax return on IRS Form 709. Any gifts in excess of $15,000 to any one person are reported on this form.
You won’t pay any gift tax because you are allowed to transfer as much as $11.2 million free of the gift or the estate tax during your lifetime. The Form 709 filing is done just to track how much you gave away so the $11.2 million limit can be reduced.
A better way to handle a transfer to the family is to disclaim the inheritance before you receive it. This means you essentially say, in a way that complies with the tax, “I don’t want those assets.”
If you disclaim any of the inheritance, it is treated as if you never received the funds. Disclaimed funds then pass to the party or parties who would have received the assets had you died before your friend.
This means that you cannot decide who will receive the disclaimed funds. That decision will be determined by the designated contingent beneficiary of the insurance policy and the 401(k) plan.
A disclaimer must have five elements. First, it must be made in writing and it must identify the asset(s) that are subject to the disclaimer.
Second, it must be made within nine months of the transfer that created the interest that is subject to the disclaimer. Third, it must be made before any benefit is received from the assets subject to the disclaimer.
Fourth, as noted above, you cannot direct who will receive the disclaimed assets. Finally, any requirements of state law to ensure the assets pass to another person without your direction must be satisfied.
The requirement that the disclaimer occur before any benefit is received can be troublesome if a retirement plan custodian has already distributed the plan participant’s required minimum distribution to the named beneficiary.
In a 2005 ruling, Revenue Ruling 2005-36, the IRS held that a disclaimer may be made even after the beneficiary has received the RMD for the year of the plan participant’s death.
You have several important decisions to make. These include any options that may be available under the 401(k) plan to receive distributions, including the possibility of a transfer of the assets to an IRA. You must also decide whether to disclaim any assets.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.