Image: Hands holding a nest with money in it © Tetra images, Getty Images

Dear Liz: I recently inherited my father's 401k due to his untimely death. He was not retired, and I'm about to graduate from college, so I'm far from retirement. While the amount is close to $50,000, my family and I have decided we would like to take out a portion, about $10,000, to put aside for a rainy day, and roll the rest over to an IRA. What are the best options to take for myself, a college student on the low tax bracket, without getting extremely penalized or taxed? -- Amanda

Dear Amanda: I am so sorry for your loss and that your dad won't be there to see you graduate from college. Please use this money to start a solid financial foundation for yourself, as he surely would have wanted.

That means you shouldn't be in a rush to tap this money, even with your current low tax bracket.

A tax-deferred account is an incredible gift, and typically you want to preserve the tax advantages for as long as possible. If this $50,000 were in your own 401k, for example, it could grow to more than $1 million by the time you hit retirement age, assuming an average 8% annual return. That return may seem high to you, but U.S. stocks have returned at least that much in every 30 year period since 1928.

You won't be able to defer taxation of this inherited account indefinitely, said Mark Luscombe, principal federal tax analyst for tax research firm CCH. IRS rules require you start paying taxes on at least some of the money. If you handle this correctly, however, you can stretch the required minimum withdrawals out over your lifetime, allowing the rest to continue to grow.

The rules would be different if you were a spouse inheriting the account, since then you could treat it as your own and delay starting distributions. Conversely, if your dad were older and had already started taking his own minimum required distributions, you would have to keep up withdrawals at the same rate. As it is, you've got the middle ground: You have to start taking some withdrawals, but they don't have to be very big.

Image: Liz Weston

Liz Weston

Here's what you need to know:

Say no to the 401k plan options. Your dad's 401k provider may want you to take a taxable distribution now, or it may give you five years and then require you to take out the whole amount. You don't want to pick either of those options.

Start fresh. You want to open up a brand-new IRA that will receive the money from this inherited account. You can't use an existing account to receive this money if you want to preserve its special tax status.

Title it right. Not only will you have to open a new IRA, but you have to make sure it's properly titled. IRA expert Ed Slott recommends you title it with your father's name and date of death, something like this: John Johnson IRA/Deceased 3/4/13 FBO (for the benefit of) Amanda Johnson as beneficiary. If you get an inexperienced customer-service representative at the brokerage where you open your account, ask to speak to a supervisor. This is not an unusual account to set up, and someone experienced should know how to do it.

Ask for a direct transfer. Tell the 401k provider to make a direct transfer into your new IRA. You don't want to receive a check or be in any way an intermediary in this transaction. The money should go directly from your dad's account into your new IRA.

Follow the minimum distribution rules for inherited IRAs. Don't mess this up, because failing to follow these rules incurs a penalty of 50% of the amount you were supposed to withdraw, but didn't.

That means:

  • You must make your first withdrawal by Dec. 31 of the year after the year in which your dad died. If he died this year, the first withdrawal must be made by Dec. 31, 2014.
  • Figure the withdrawal by dividing the amount in the account as of Dec. 31 of the previous year by your life expectancy. You can find life expectancy figures in IRS Publication 590, "Individual Retirement Arrangements." If you'll be 21 on Dec. 31, 2014, for example, you'll divide the balance as of Dec. 31, 2013 by 62.1 years of life expectancy. If the balance is $50,000, you'll withdraw and pay taxes on $805. For each subsequent year, you reduce the divisor by 1 to account for the change in your life expectancy.

If you're good with spreadsheets, you can set one up to show how much you would have after 40 years of these distributions. The one I created shows you with nearly $370,000 after 40 years — while you would have taken out more than $225,000 in distributions. That assumes a steady 8% annual return, which you won't get; some years you'll make more, some years you'll lose money. But you can see why preserving as much tax deferral as possible is such a good idea.

Age

Dec. 31 balance*

Life expectancy

Required

distribution

Remaining balance

21

$50,000

62.1

$805

$49,195

22

$53,130

61.1

$870

$52,261

23

$56,442

60.1

$939

$55,503

24

$59,943

59.1

$1,014

$58,929

25

$63,643

58.1

$1,095

$62,547

26

$67,551

57.1

$1,183

$66,368

27

$71,678

56.1

$1,278

$70,400

28

$76,032

55.1

$1,380

$74,652

29

$80,624

54.1

$1,490

$79,134

30

$85,465

53.1

$1,610

$83,855

31

$90,564

52.1

$1,738

$88,825

32

$95,931

51.1

$1,877

$94,054

33

$101,578

50.1

$2,028

$99,551

34

$107,515

49.1

$2,190

$105,325

35

$113,751

48.1

$2,365

$111,386

36

$120,297

47.1

$2,554

$117,743

37

$127,163

46.1

$2,758

$124,404

38

$134,357

45.1

$2,979

$131,377

39

$141,888

44.1

$3,217

$138,670

40

$149,764

43.1

$3,475

$146,289

41

$157,992

42.1

$3,753

$154,239

42

$166,579

41.1

$4,053

$162,526

43

$175,528

40.1

$4,377

$171,150

44

$184,842

39.1

$4,727

$180,115

45

$194,524

38.1

$5,106

$189,419

46

$204,572

37.1

$5,514

$199,058

47

$214,983

36.1

$5,955

$209,027

48

$225,750

35.1

$6,432

$219,318

49

$236,863

34.1

$6,946

$229,917

50

$248,311

33.1

$7,502

$240,809

51

$260,073

32.1

$8,102

$251,972

52

$272,129

31.1

$8,750

$263,379

53

$284,449

30.1

$9,450

$274,999

54

$296,999

29.1

$10,206

$286,793

55

$309,737

28.1

$11,023

$298,714

56

$322,611

27.1

$11,904

$310,707

57

$335,563

26.1

$12,857

$322,706

58

$348,523

25.1

$13,885

$334,637

59

$361,408

24.1

$14,996

$346,412

60

$374,125

23.1

$16,196

$357,929

61

$386,564

22.1

$17,492

$369,072

Total withdrawn:

$226,072

 

Amount remaining:

$369,072

 

*Assumes 8% annual growth

You should set all this up even if you think you may have to take out a lump sum later. You can still do that under this approach without penalty, although you will have to pay income taxes on the withdrawal. But if you don't take this approach, you'll subject the whole inheritance to taxation, and that would be a waste.\

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.

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