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IRAs after a life tragedy
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April 3, 2000: 8:13 a.m. ET
Facing an illness, you can put your 401(k) money in an IRA rollover
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NEW YORK (CNNfn) - If tragedy strikes and you face a serious illness that forces you to leave your job, you might be wondering what to do with your 401(k).
In response to a reader's question, Frank Armstrong, a certified financial planner and president of Managed Account Services, said an IRA rollover might be a good idea.
Ask the experts a question.
I have a 53-year-old friend who has been diagnosed with cancer. He has six months to live. His company has terminated him, so he has to transfer his 401(k). He is married. If he rolls the 401(k) into a traditional IRA, his taxes will be deferred. What happens to the IRA when he dies? Does it pass to his wife in a liquid form or is she not allowed to withdraw the money?
Properly accomplished, an IRA rollover can defer taxes on the 401(k) proceeds for the balance of your friend's life, and for the life of his heirs. At the same time, they can count on penalty-free withdrawals as needed to support their income needs.
Your friend can roll his 401(k) into a traditional IRA. By completing a direct "trustee-to-trustee" rollover, he avoids any tax or withholding problems. If he is fully disabled, he qualifies for penalty-free distributions from the IRA account during his life, regardless of his age.
He should carefully complete both his primary and contingent beneficiary on the new IRA account so that the funds go to surviving spouse and/or other heirs. It is not sufficient to name the "estate" as a beneficiary. This would subject the account to disbursal and income taxes shortly after his death.
Naming a trust is generally a very bad idea, but if very carefully drawn, a "qualifying" trust may preserve the benefits of deferral for the beneficiaries. The requirements are complex, and the IRS is not known for leniency. So, if a trust is named, it should be drafted by a very capable tax attorney.
Presuming that he names his wife as beneficiary, she has the following two choices after his death:
1. Continue the account as a "beneficiary" account. The biggest advantage of this course is that the surviving spouse can make withdrawals free of penalty tax under the "account of death" exemption regardless of her age. Amounts not withdrawn continue to appreciate tax deferred.
2. Roll the account into her own IRA. A potential advantage of this approach is that if she is younger, she would be able to defer forced withdrawals that would occur when the original account holder would have turned age 70-1/2. However, if she does this and she is under age 59-1/2, she will be subject to the penalty tax on premature withdrawals unless she qualifies for one of the special exemptions: death, disability, first time home purchase, etc.
If she continues the account as a beneficiary, and she begins to make withdrawals, she may be no longer able to convert the account to her own at a later date. So, in some cases it is appropriate to consider splitting the account into a beneficiary account and spousal rollover before she takes any withdrawals. That way she can utilize the beneficiary account until she turns 59-1/2, and still be able to defer taxes on the spousal rollover account until late in her life.
The spouse must make timely elections to accomplish either rollover by Dec. 31 of the year following the year of death to prevent accelerated distributions as a result of the account holder's death. The spouse should also make appropriate beneficiary designations on the accounts at her earliest possible convenience to protect her own heirs.
I have tried to be as clear as is possible under the circumstances. But, the tax code is unnecessarily complex, unclear, arbitrary and capricious. In addition, we have been all operating under proposed regulations for several years! So, if either of the couple have any doubts about the appropriate elections, they would be well advised to get professional advice now regarding this and all other estate planning issues. 
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