No beneficiaries on decedent's 401k. How can I reduce my tax burden?

[SendingtheWolf]

My father died unexpectedly and had a sizeable 401k, roughly $450k. He wasn't planning on dying so he didn't list a beneficiary. With no spouse or beneficiaries, the plan requires the money to go to the estate, so it can't be rolled over. It'll be disbursed and treated as ordinary income.

Here's where I'm looking for help making the best decision for my family's inheritance. Bear with me, this is a little complicated. I'm married, filing separately since my wife is doing income-based repayment nearly $200k in student loans that have been growing since she graduated with her doctorate. Our long-term plan with her loans are using the student loan forgiveness program since she's teaching, working for the government. She makes her payments for 10 years and the government promises to pay off her debt.

At her current income, she owes about $100/month. If we filed jointly in the past, my income is counted and her income-based payments will go up to around $1200 per month, but it may go up to even $2400 per month if we file jointly and they see the ordinary income from my dad's 401k disbursement.

Looking at the income brackets and differences between married filing separately and married filing jointly, at my current income I would be looking at about a $25,000 difference between the two different filing types. It looks like, because of the way the loan repayment is structured, we're just stuck going with married filing separately?

I'm doubtful there are any good options here (aside from donating it all to charity) to save on taxes. Anyone have any thoughts on how I can work through this tax situation?

P.S., designate a beneficiary, folks. My dad was methodical about his retirement savings and he wouldn't be happy to see this much going to uncle sam.

[terran]

I was so sure this had to be a mistake, but from what I've been able to find you and the custodian seem to be right that is (or at least can be, depending on the custodian) how it works. Bummer.

Sorry for your loss (both personal and financial), and on behalf of anyone who hasn't, thanks for the reminder to name beneficiaries on all retirement accounts.

[chicagomeg]

How much longer until her loans are forgiven? I'd be inclined to just pay off the wife's student loans with the windfall.

[Proud Foot]

I'm sorry to hear about your loss.

A few things to think about regarding the taxes and student loan forgiveness:
What is the current difference between your taxes MFS and MFJ not counting this 450k? Try to estimate this yearly for each year you file MFS for the IBR plan.
Is the forgiven loan balance treated as income in the year forgiven? (Is this a thing? I'm not familiar with student loan forgiveness programs)

I would work the numbers and consider what would happen if you were to just pay off her student loans with the inheritance and then invest the remaining portion.

Also, if not already doing it, make sure you max out all available tax deferred accounts for yourself and your wife.

[secondcor521]

I would HUACA (*) the HR people.  According to this article:

https://www.thebalance.com/inherited-401k-distribution-and-withdrawal-rules-2388269

(which is the first random article I found googling "401k estate stretch") says that even for a non-spouse, you should have the option of either a 5 year distribution period or RMDs over the beneficiaries lifetime.  Even though it is inherited through the estate rather than through beneficiary designation, it still is inherited, and so you should at least be able to roll it to an inherited IRA and take it out evenly over five years.  Inheriting a 401(k) via the estate does rule out the RMD option.

I agree with what others have said about running the numbers about just paying off your wife's loan and/or evaluating MFJ vs MFS.

(*) HUACA = hang up and call again.  Meaning try someone else in HR because the first person you talked to might be uninformed or misinformed.  It might also be worth it to request a copy of the 401(k) plan document to clarify what your options are.  Plan documents can be dense reading but are generally reasonably understandable to the average person.

[SendingtheWolf]

How much longer until her loans are forgiven? I'd be inclined to just pay off the wife's student loans with the windfall.

It will be a while. She’s only been making qualified payments for about a year. Because of the low payments, her principal has increased by a lot over the last couple of years. Good she keeps up income based repayment until 10 years is up, I’d have to do do the math but I shutter to think what the principal might be. I’ve considered repaying it, but also other alternatives look attractive.

[SendingtheWolf]

I would HUACA (*) the HR people.  According to this article:

https://www.thebalance.com/inherited-401k-distribution-and-withdrawal-rules-2388269

(which is the first random article I found googling "401k estate stretch") says that even for a non-spouse, you should have the option of either a 5 year distribution period or RMDs over the beneficiaries lifetime.  Even though it is inherited through the estate rather than through beneficiary designation, it still is inherited, and so you should at least be able to roll it to an inherited IRA and take it out evenly over five years.  Inheriting a 401(k) via the estate does rule out the RMD option.

I agree with what others have said about running the numbers about just paying off your wife's loan and/or evaluating MFJ vs MFS.

(*) HUACA = hang up and call again.  Meaning try someone else in HR because the first person you talked to might be uninformed or misinformed.  It might also be worth it to request a copy of the 401(k) plan document to clarify what your options are.  Plan documents can be dense reading but are generally reasonably understandable to the average person.

I will try this. I am fairly confident what HR is telling me is correct, though. I ran the numbers on MFS and MFJ a while ago and it was a no brainer, but with the windfall, it might change things

[SendingtheWolf]

I'm sorry to hear about your loss.

A few things to think about regarding the taxes and student loan forgiveness:
What is the current difference between your taxes MFS and MFJ not counting this 450k? Try to estimate this yearly for each year you file MFS for the IBR plan.
Is the forgiven loan balance treated as income in the year forgiven? (Is this a thing? I'm not familiar with student loan forgiveness programs)

I would work the numbers and consider what would happen if you were to just pay off her student loans with the inheritance and then invest the remaining portion.

Also, if not already doing it, make sure you max out all available tax deferred accounts for yourself and your wife.

Oh my. I hadn’t thought about the loan forgiveness being taxed when paid out. Ouch. I’ll check on that. If I pay off her loan, that wouldn’t be an offset to income, would it? No, that would be wishful thinking. I think I saw that the max deductible would be $2500 in interest paid.

[secondcor521]

@lhamo, it's not estate or inheritance taxes at issue.  If the OP's father died with a tax-deferred account balance in his 401(k), then when that money is distributed from the 401(k) (unless it's to another tax-deferred account, like an inherited IRA), there is income tax due.

In other words, it's the fact that the money is leaving tax-deferred space, not that it's being inherited.

Again, I'd urge OP to try to find an option where the money can stay in tax-deferred.  I would hope at least there's the "roll it to an inherited IRA and draw down the account over five years" option.

[SendingtheWolf]

@secondcor521

Regrettably, there is no option for a rollover, since it has to go to the estate and the estate cannot do a rollover. I’m 99% sure on this but I will double check the plan fine print as suggested earlier. The 5 year draw down would be much better,  if possible.

Someone asked earlier about tax being owed on my wife’s loan forgiveness when it’s paid off. I found the answer: since it is a public service loan forgiveness program, no tax is due on the forgiven amount. So at least I won’t need to consider that in my calculations.

[secondcor521]

@secondcor521

Regrettably, there is no option for a rollover, since it has to go to the estate and the estate cannot do a rollover. I’m 99% sure on this but I will double check the plan fine print as suggested earlier. The 5 year draw down would be much better,  if possible.

Someone asked earlier about tax being owed on my wife’s loan forgiveness when it’s paid off. I found the answer: since it is a public service loan forgiveness program, no tax is due on the forgiven amount. So at least I won’t need to consider that in my calculations.

Bolded by me.  I was going to challenge this point, but in googling I was surprised to find out it was correct.  There is a "two year distribution" idea here:

https://www.irahelp.com/forum-post/26743-401-k-death-owner-no-beneficiary

"Another goal is to avoid having the distribution taxed to the estate, which would be at high fiducuary tax rates.  If a lump sum distribution from the 401(k) plan cannot be avoided, the tax imposed on the daughters can be somewhat mitigated by having the estate make two distributions to each of the daughters, with the first in 2016 and the second in 2017, but all within the first fiscal tax year of the estate.  This will spread the distribution to the daughters over two calendar tax years, and may help to prevent their tax rate from going to a higher bracket.  But the distribution will be fully made within the first fiscal tax year of the estate, which will reduce or eliminate paying tax at the high fiduciary tax rates."

[SendingtheWolf]

@secondcor521

Regrettably, there is no option for a rollover, since it has to go to the estate and the estate cannot do a rollover. I’m 99% sure on this but I will double check the plan fine print as suggested earlier. The 5 year draw down would be much better,  if possible.

Someone asked earlier about tax being owed on my wife’s loan forgiveness when it’s paid off. I found the answer: since it is a public service loan forgiveness program, no tax is due on the forgiven amount. So at least I won’t need to consider that in my calculations.

Bolded by me.  I was going to challenge this point, but in googling I was surprised to find out it was correct.  There is a "two year distribution" idea here:

https://www.irahelp.com/forum-post/26743-401-k-death-owner-no-beneficiary

"Another goal is to avoid having the distribution taxed to the estate, which would be at high fiducuary tax rates.  If a lump sum distribution from the 401(k) plan cannot be avoided, the tax imposed on the daughters can be somewhat mitigated by having the estate make two distributions to each of the daughters, with the first in 2016 and the second in 2017, but all within the first fiscal tax year of the estate.  This will spread the distribution to the daughters over two calendar tax years, and may help to prevent their tax rate from going to a higher bracket.  But the distribution will be fully made within the first fiscal tax year of the estate, which will reduce or eliminate paying tax at the high fiduciary tax rates."

This will help a lot. Thanks for posting this. Now that I think about it, I had to set a fiscal year when I set up the EIN for the estate, which will end in April next year. So I can pay out when the estate settles this year (October, maybe) half of the money, and the other in January, and it'll be spread out over two years. That will allow me to leverage a maxed 401k, child tax credits, and a $6000 deposit to my IRA over 2 years, and report an overall lower ordinary income. This seems to be the best option so far. Thanks!

[SendingtheWolf]

Okay, I ran the numbers. Being able to spread the windfall over 2 years lets me capitalize on 401k and IRA distributions over 2 years and lowers my overall tax brackets enough to save an estimated $8,667 in taxes. It's nowhere near comparable to being able to do an inherited IRA rollover, but it's significant, and apparently the only option.