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February 2021

Monitoring Direct Rollovers of Inherited 401(k) Funds to an inherited IRA

Tax problems will exist if inherited 401(k) funds which are to be directly rolled over to an inherited IRA are directly rolled over to a person’s regular IRA. The mistake most often will be unintentional, but there could be times when the mistake would be intentional.

An IRA custodian/trustee must develop good procedures for processing direct rollovers from 401(k) plans and other retirement plans.

Your financial institution no doubt has had a customer come in with a check made payable to the bank for their benefit. For example, a check is issued by ABC 401(k) profit sharing plan to First State Bank fbo John Doe. You will need additional information to assist your customer. Has John Doe instructed to have a direct rollover into his own personal IRA or into an inherited IRA? The 401(k) plan’s check may not be a precise as it should be.

IRS rules do not discuss very thoroughly the information the 401(k) trustee must or may provide the IRA custodian/trustee. Under current laws there is no express exception to privacy rules allowing the 401(k) administrator to furnish certain information to the IRA custodian/trustee. Common sense says there should be, but there isn’t.

There are IRS rules requiring the 401(k) trustee to furnish a 401(k) participant or beneficiary with a comprehensive distribution form. This IRS has provided a safe harbor distribution form. It sets forth in detail the tax rules and options available to participants and beneficiaries in most every distribution situation. This form is often called a section 402(f) notice. After reading this form, the participant or beneficiary is to instruct whether they wish to have a direct rollover, take a cash withdrawal (but there is 20% mandatory withholding) or to do both a partial direct rollover and a partial cash withdrawal.

An individual certainly wants to keep a copy of their completed distribution form in their file.

An IRA custodian/trustee should try to obtain a copy of this distribution form from their IRA client. An IRA custodian/trustee may try to obtain additional information from the 401(k) plan.

An IRA custodian/trustee needs to watch (and prevent) the following situation from happening.

John Doe brings into your bank a check for $130,000. It has been issued by the ABC 401(k) plan to “First National Bank for benefit of John Doe.” He wants to put it into his traditional IRA. John Doe is age 52.

Note it does not state “John Doe’s IRA”or “John Doe’s Inherited IRA.” The IRA customer service representative sees a form showing the 401(k) plan will be issuing him a Form 1099-R with reason codes 4G to be reported in box 7 of Form 1099-R. The “4” denotes death and the “G” denotes a direct rollover.

When a 401(k) participant dies, their beneficiary must comply with the beneficiary RMD tax rules and they must comply with the requirements of the 401(k) plan document. Although the tax rules may allow the beneficiary 5-years to withdraw the inherited funds, many time the 401(k) plan document will require a beneficiary only 1-2 years to withdraw the inherited funds. Many non-spouse beneficiaries will exercise their right to direct rollover the funds into an inherited IRA. A spouse beneficiary has the right to have direct rollover into their own IRA or they could elect to have it go into an inherited IRA. As illustrated above there will be times when a 401(k) plan’s procedures are not what they should be. It is not clear from the check that these funds must go into an inherited IRA for John Doe rather than his own personal IRA. In some cases, John Doe may try to cheat and contribute these funds to his personal IRA rather than into an inherited IRA. By doing this the person is trying to avoid the law requiring immediate RMDs. It is irrelevant that his name alone is listed on the check. Inherited 401(k) funds are only eligible to be directly rolled over into an inherited IRA.

The IRS has provided guidance for when an IRA owner dies and an inherited IRA will be set up for the beneficiary. In the instructions for Form 5498, the IRS writes, you may use as the title, “Brian Willow as beneficiary of Joan Maple”.

The IRS needs to provide guidance on direct rollovers of inherited funds. See the IRS instructions for Forms 1099-R and 5498. The IRS has not provided guidance as to how the inherited IRA should be titled if the inherited IRA is established because a beneficiary of a deceased 401(k) participant exercises his or her right to have a direct rollover to an inherited IRA. The above titling should also be used for this situation.