BEFORE THIS YEAR

, many nonspousal beneficiaries had no tax-saving option when they inherited all or part of a deceased person's qualified retirement plan account. By qualified retirement plan, we mean a 401(k) plan, profit-sharing plan, stock bonus plan, or the like.

For instance, say you inherit part of your Uncle Floyd's 401(k) account. The plan's operating rules may allow it to completely cash you out shortly after Uncle Floyd's death by distributing your share of the account balance to you. Until now, you had to pay the resulting income tax hit in the year you received the distribution. More rarely, the plan might allow you to leave your share in Uncle Floyd's 401(k) account for five years or longer and thereby continue to defer taxes, but that would be the exception rather than the rule.

In other words, you weren't allowed to defer taxes by rolling over the distribution from Uncle Floyd's account into an IRA of your own. That tax-saving privilege was limited to spousal beneficiaries. So under the pre-2007 rules, Uncle Floyd's surviving wife could defer taxes by rolling over the distribution of her share of the 401(k) account into an IRA. But you had no such opportunity.

Now, Things Have Changed in Your Favor

Happily, things change. Beginning in 2007, a nonspousal beneficiary of a deceased person's qualified retirement plan account (including a Section 403(a) annuity, a Section 403(b) annuity, or a governmental Section 457 plan account) can set up an IRA to receive a tax-free rollover of a plan distribution.

Bottom Line: You can now defer taxes on a distribution from Uncle Floyd's 401(k) account. Here's the rest of what you need to know to do the tax-smart IRA rollover drill.

Rollover Mechanics

The rollover into a nonspousal beneficiary's receiving IRA must be accomplished via a direct (trustee-to-trustee) transfer that does not pass through the beneficiary's hands. So if Uncle Floyd's 401(k) plan issues a check payable to you personally, you cannot make an IRA rollover, and you'll have to include the entire taxable amount of the distribution on your income tax return for the year you receive the payout.

The IRA that you set up to receive an inherited retirement plan distribution will still be in the deceased person's name, but it will be effectively under your control. For example, the receiving IRA might be titled something like this: "Giant Bank and Trust, Custodian, for IRA of Floyd Johnson, Megan Johnson, Beneficiary."

After the Rollover...

Basically, what this means is that you can gradually draw down the balance in the receiving IRA over your life expectancy and potentially reap many years of tax deferral benefits. Here are two examples to illustrate why you should greet the new IRA rollover option with enthusiasm:

Example 1: Let's say you're the sole designated beneficiary of Uncle Floyd's 401(k) plan account. He passes away in 2007 at age 63. You inherit the account which is worth $100,000. Under the 401(k) plan's operating rules, a beneficiary (you) must be cashed out shortly after the plan participant's (Uncle Floyd's) death. However, you don't want to receive a taxable distribution. You prefer to defer taxes instead. Here's how to do it:

Step 1: Set up an IRA to receive the $100,000 distribution from Uncle Floyd's account.

Step 2: Instruct the 401(k) plan trustee to directly transfer the $100,000 into the receiving IRA in a tax-free transaction. Do this by the end of 2007.

Step 3: For 2008 and beyond, comply with the required annual minimum withdrawal rules for an inherited IRA. Otherwise, you'll be charged a penalty equal to 50% of the difference between what you should have received each year and what you actually received.

In this particular example, you must begin taking required minimum withdrawals by no later than Dec. 31 of the year after the year of Uncle Floyd's death (i.e., by Dec. 31, 2008, in this case). The withdrawal for each year is calculated by dividing the receiving IRA's balance as of the end of the previous year by the single life expectancy divisor based on your age as of the end of the current year.

Thankfully, the required withdrawals can be a surprisingly small percentage of the receiving IRA's balance, which means the income taxes that you'll have to pay can also be surprisingly small. For example, assume you'll be 41 as of Dec. 31, 2008 (the end of the year during which you must receive the initial required minimum withdrawal in this example). The mandatory withdrawal for 2008 will be only 2.34% of the receiving IRA's 12/31/07 balance. For 2009, the mandatory withdrawal will be only 2.40% of the 12/31/08 balance. As you can see, it's very possible that the receiving IRA will actually continue to grow despite the required minimum withdrawals.

The point is, you can benefit from many years of tax deferral if you take out only the required minimum withdrawal amount each year. Of course, you can always choose to receive more, but that would cause you to lose out on part of the receiving IRA's valuable tax-deferral advantage.

Example 2: Same basic facts, but this time let's assume that Uncle Floyd died on or after April 1 of the year after turning age 70 . In this scenario, a required minimum withdrawal must be taken out of the 401(k) account for the year of death (2007 in this example) before anything can be rolled over into the receiving IRA. For instance, if Uncle Floyd dies in 2007 at age 73, a mandatory withdrawal for 2007 must be paid out of the 401(k) account to you as the account beneficiary. You would owe the related taxes.

Then you can then roll over the remaining 401(k) account balance into the receiving IRA before the end of this year. You must then take the initial required minimum withdrawal from the receiving IRA by no later than Dec. 31, 2008. The 2008 mandatory withdrawal and the mandatory withdrawals for later years would be calculated using single life expectancy divisors based on your age as of the end of each year. Once again, you could benefit from many years of tax deferral if you take out only the required minimum withdrawal amount each year.