Updated Monday, July 28, 2014 as of 6:36 PM ET
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Ask Ed Slott: Converting Inherited Plan Funds
Friday, May 24, 2013
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Can non-spouse beneficiaries of an employer-sponsored 403(b) TSA plan convert inherited TSA funds to inherited Roth IRAs?  

Inherited plan funds can be converted via DIRECT rollover (i.e. not a 60-day rollover) to a properly titled inherited Roth IRA. There are certain requirements that must be met. The beneficiary must inherit the plan funds as a named beneficiary, not through the estate or a non-qualifying trust. The funds must go as a direct rollover from the plan to the inherited account; they cannot be made payable to the beneficiary. Any required distributions from the plan are not eligible for rollover and should be paid out from the plan first.

The transfer of the inherited plan funds to an inherited Roth IRA will be a taxable event to the beneficiary. The beneficiary will have required distributions from the inherited Roth account.  Because of these two factors, a Roth conversion by a beneficiary might not make sense, particularly if they have their own retirement funds they could be converting instead.

Congress (finally!) approved the requried changes to the Internal Revenue Code in early January, but apparently the federal government has not yet published the regulations with the specifics on in-service Roth IRA conversions.  My plan's recordkeeper tells me that without the regulations in hand, they cannot set up software to process conversions of funds from traditional 401(k)s, 457(b) plans, etc. for people who have not separated from their employers. 

Is there some date when the regulations will be finalized?   We're halfway through the year, and I would like to get started on it this year and have enough time to adjust my paycheck withholding to cover the taxes due on my first increment of conversion.

There is no way of knowing when IRS might be releasing regulations. They have now scheduled several furlough days where all of IRS will be shut down due to the sequester. This could push the release back even further.

Does the 3.8% investment tax apply to retirement funds?  For example, if I take a lump-sum distribution of my 401(k) plan, which holds employer stock, will the basis be taxed at 3.8% on top of income tax and will the NUA (net unrealized appreciation) be taxed at 3.8% on top of capital gains at the time I sell the stock? 

The investment surtax of 3.8% does not apply to most retirement payments. It could apply to certain non-qualified annuity payments. However, the retirement payment will increase your income and could put you over the threshold to where the surtax will apply.

Example: The surtax will apply if MAGI (modified adjusted gross income) is over $250,000 (individuals married, filing jointly). A couple’s MAGI is $235,000. Then they take a distribution from an IRA of $25,000. This increases their MAGI to $260,000 ($235,000 + $25,000 = $260,000). They are now $10,000 over the threshold and some of their investment income would be subject to the surtax.

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