I have two daughters, 21 and 23, and their mom (my ex-wife) died March 2020. My daughters inherited 401(k) money as their mom was currently employed and they inherited IRA money too. I read an article you wrote concerning turning an inherited 401(k) funds into a Roth. I’m unsure of the process and can’t really find any literature pertaining to the topic. Might you be able to help?
A.: I’m so sorry for your family’s loss, Jay. A few thoughts come to mind.
If the 401(k) was funded with pretax contributions, any amount converted will be taxable to them but converting to Roth could be a good move because at 21 and 23, they are likely in a low tax bracket. If they convert, invest prudently, and leave the funds alone, in 2030 they could get a good chunk of money tax-free at a time when they may be in a higher tax bracket.
Inherited IRA money cannot be converted to Roth IRAs, but it is allowable under the law to convert inherited 401(k) assets directly into Inherited Roth IRA accounts. The girls would each set up an Inherited Roth IRA account. Then they instruct the 401(k) to send their shares directly to their Inherited Roth IRA accounts. The checks should be made payable to the Inherited Roth IRA not your daughters as individuals. If they get a check individually, it is considered a distribution not eligible for rollover.
The amount converted is taxable income to the girls in the year of the conversion but once that is done, they can get any of those converted funds out tax-free at any time. The normal 5-year rule for conversions does not apply because the distribution from the 401(k) is due to the death of the participant.
If they do not withdraw all the amount converted before the fifth tax year after the conversion, they will then be able to get earnings out tax-free, too. Because their mother died after 2019, they could choose to leave the money alone and let it grow tax-free until 2030. At the end of that year, they must empty the account, but all the money received will be tax-free.
One complication for your daughters if they are still in school is the effect these funds may have on their financial aid. Generally, inherited retirement accounts are not counted as assets on the Free Application for Federal Student Aid (FAFSA). However, income from such accounts, including income from a conversion can count. Even distributions from an Inherited Roth IRA that are not taxable can be counted as income for student aid purposes. If they are receiving financial aid, they should consult with an adviser to assess all the trade-offs. They may want to delay taking any funds from the inherited accounts or converting.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.