One of the necessities when enrolling for a 401(k) plan is that one has to nominate beneficiaries for the plan. The person can nominate their spouse, children, dependent, any person, group of persons or a trust as the beneficiary where in the event of the account holder’s death, the funds of the 401(k) account go to the beneficiary.

Up till a few years ago, only the spouse of the account holder could transfer the amount directly into their 401(k) account or an Individual Retirement Account (IRA) without paying any taxes or penalties. Non-spouse beneficiaries had to take a lump sum withdrawal from the plan administrator which would be subject to local and state (if applicable) and federal taxes.

However, with the new law passed by the Congress under the Pension Protection Act (2006), non-spouse beneficiaries can now inherit funds of the 401(k) account directly into their own Inherited IRA which has to be established specially for transferring the amount from the 401(k). Although there are certain rules that govern the transition of the funds and not adhering to these can result in taxes.

The money from deceased’s 401(k) account should be rolled over directly into the new inherited IRA account. Taxes will be levied even if the beneficiary receives a check for the amount and deposits the same in the inherited IRA. The new account cannot be anything other than an ‘inherited IRA’ where the title must comprise of an exact replica of the original 401(k) account (original account holder’s name, as is) and the person/entity inheriting the funds must be listed as the beneficiary. Hence, extreme caution must be taken and proper instructions must be given to the plan administrator and the bank or firm that handles the inherited IRA so that their mistake does not cost the beneficiary dearly.

Also, it is against the rules to transfer the 401(k) funds into the original account holder’s estate. The only allowed beneficiaries are any person, group of people or a trust where the beneficiary has to take distributions calculated as per and stretched over, their life expectancy. These will be taxed upon withdrawal.

This allows the 401(k) beneficiary to take distributions spanning over their lifetime which can be seen as an advantage since the beneficiary is not burdened with heavy taxes that they would have incurred had they been forced to take a lump sum withdrawal. This also provides the beneficiary with proper inheritance that they are entitled to rather than having to ship off a bigger chunk of the inheritance in taxes to the IRS.

In addition to these benefits, beneficiaries also get a benefit of IRA with the shifting of the funds apart from the tax deferred amount. And as per the new law, even beneficiaries can make hardship withdrawals from the participants account. Hence, they have more access to the funds.