Tax Break Extended to All 401(k) Heirs
A little-noticed provision in a pension law signed Thursday by President Bush will for the first time allow anyone to inherit a 401(k) nest egg without immediately paying taxes on the windfall, a benefit that in the past was reserved for spouses.
Gay advocates and other observers described the measure as a significant shift in how the government treats domestic partners who are not married, even though the provision was not written specifically for same-sex couples.
“With this change, Congress is acknowledging that improvements can be made to our laws that address financial inequities and impediments that same-sex couples face,” said James M. Delaplane Jr., an attorney and specialist on pension benefits. “There’s no doubt about it.”
The legal change is an obscure element in a new 907-page law affecting pensions and workplace-based retirement accounts. Proponents of the overall package hailed it as a long-sought effort to stabilize a system of retirement benefits that has grown porous. Many traditional pension plans are teetering on a base of shaky funding, and many companies are cutting back on future commitments.
“Americans who spend a lifetime working hard should be confident that their pensions will be there when they retire,” Bush said as he signed the Pension Protection Act of 2006.
The change also was supported by much of the financial service industry, which is scrambling after a lucrative retirement-investment market as the baby boom generation gets older.
Much of the new law sets out standards that companies must follow in funding their pensions. But it also covers an array of other matters, including the rules affecting the transfer of 401(k) accounts and other so-called defined-contribution plans, upon death.
Federal law has always allowed a spouse who inherits a 401(k) account to put the money into his or her own retirement savings account without penalty. But anyone else -- including a child of the deceased -- typically has been required to withdraw all funds from the account and pay taxes on the income within a matter of months. Such an inheritance also has forced some survivors into a higher tax bracket, further increasing their tax burden.
Under the new provision, other heirs besides spouses will be able to roll an inherited 401(k) account into an individual retirement account and not pay taxes on the income immediately, perhaps not for many years. A non-spouse heir’s tax payment schedule will be tied to the age of the account’s former owner.
Experts say the rule, which takes effect next year, could save many heirs tens of thousands of dollars each in taxes.
People holding 401(k) accounts frequently designate non-spouses such as siblings, parents and children to receive the money in these accounts upon their death. While there are no precise numbers on those who would gain under the change, more than 65 million Americans participate in 401(k) and similar workplace-based retirement plans, according to the Department of Labor.
For some, the new provision called to mind a rule change affecting the federal death benefits for survivors of safety officers killed in the line of duty, which was passed after the terrorist attacks of Sept. 11, 2001. That change allowed safety officers to name a broader group of beneficiaries, including domestic partners, to receive the money.
The pension bill, however, encompasses the whole public, rather than members of one occupation.
“I think it’s incredibly significant, and I think it’s historic,” said Joe Solmonese, president of the Human Rights Campaign, a gay rights organization. “What we really are seeing here, I think, is a huge step toward leveling the field.”
“It’s a meaningful part of the story,” said J. Mark Iwry, a Brookings Institution scholar and former Treasury Department pension official. “The gay community should definitely benefit.”
The move was made quietly and without controversy. In Congress, the idea of easing restrictions on the transfer of nest eggs was generally described as a fairness issue for family members and was not framed as a gay rights issue.
Such a provision passed House and Senate committees as long ago as 2003. Among the early proponents was Rep. Rob Portman (R-Ohio), then an influential House member on pension issues and today the director of the White House Office of Management and Budget. Portman could not be reached for comment Thursday.
A socially conservative lobby in Washington reacted favorably to the pension provision, emphasizing its positive effect on close relatives.
“We see it as a family issue,” said Michele Combs, spokeswoman for the Christian Coalition of America. “We like the fact that you can leave your pension to more heirs.... We see the positive side of it.”
The practical effect of the old rule has been to shrink the amount passed on to non-spouses, because of taxes, and to complicate financial planning.
“It made our job harder,” said David E. Ratcliffe, director of the Merrill Lynch Center for Philanthropy and Nonprofit Management. The change, he said, makes for “an expanded market” for retirement planning because more money will be available to invest.
Employers and benefit advisors also supported the change.
“It’s something our members identified as an important improvement for defined-contribution plans,” said Jan Jacobson, director of retirement policy for the American Benefits Council, which represents employers. “We were gratified to see it in the final bill.”
Experts said heirs would not be treated the same as spouses in all matters related to retirement accounts.
For example, non-spouses will have to draw down the accounts on a schedule determined by the age of the account’s deceased former owner rather than their own age and retirement status, Jacobson said. Spouses make such withdrawals based on their own age, or as they move into retirement.
Yet even with such fine print, the new law could make a huge difference for a household, and could save survivors tens of thousands of dollars or more in taxes, said Ed Slott, a specialist in retirement planning.
“It’s a great provision for all non-spouses,” he said.
