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One of the most common assets after the passing of a loved one is a retirement account. According to The CPA Journal, there are about 48.9 million households that own one or more retirement accounts, totaling a whopping $5.4 trillion. Of these, 39 percent are held by individuals from the baby boomer generation.
Given the significant number of older individuals holding 401(k)s, 403(b)s and various IRA and other retirement accounts, a substantial transfer of assets is expected to occur from baby boomers to their heirs over the next two decades.
With an overwhelming number of rules and regulations to decipher, many of my clients find themselves unsure of how to proceed if they inherit retirements assets. They also feel unsure about what to do with their retirement assets when thinking through their own estate plan.
Here's what to know about inheriting a retirement account so you'll have the knowledge and tools to make the most of your inheritance (or the inheritance you're leaving behind) and avoid common mistakes. From understanding the different types of beneficiaries to exploring strategies for minimizing taxes, I've got you covered.
Understanding the Basics of Inheriting a Retirement Account
Inheriting a retirement account can be a significant financial event in your life. It's crucial to have a solid understanding of the basics so you're able to make informed decisions about what to do with the account(s). The first step is to determine the type of retirement account you've inherited and what you'll need to do with it. There are various types of retirement accounts, including 401(k)s, 403(b)s, traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs.
Retirement Account Options When You're the Spouse
If you were married to the deceased, you have a couple of options for the account.
You can rollover (move) the funds into your own IRA and use your required minimum distribution (RMD) age. This may be beneficial if you're younger than they were and won't need the money before you turn 59 1/2.
You you can rollover the funds into an inherited IRA account and take distributions at any time without paying the 10% early withdrawal penalty.
Retirement Account Options When You Aren't the Spouse
You can take a lump sum distribution, meaning you cash out the full amount in the account. You won't have to pay a 10% early withdrawal penalty, but you will pay ordinary income tax. If it's a large sum of money, it could put you in a higher tax bracket.
You can transfer the funds from any of these types of retirement accounts into an inherited or beneficiary IRA account that's in your name.
From there, the rules and regulations regarding distributions (withdrawals) and taxes owed on your inheritance are based on whether or not you're considered an eligible designated beneficiary.
What's an Eligible Designated Beneficiary and Who Is (and Isn't) Considered One
An eligible designated beneficiary for an inherited retirement account has more favorable distribution options when it comes to taxation versus non-eligible designated beneficiaries due to the SECURE Act, which became law in 2020.
Who is considered an eligible designated beneficiary?
Spouses
Minor child(ren) under age 18
Disabled or chronically ill individuals
Individuals 10 years or younger than the account owner
Who is not considered an eligible designated beneficiary?
Anyone else, including adult children, a business partner, a relative, etc.
This includes a non-individual, like a trust, charity or organization.
Once you've properly transferred the retirement account funds into an your own or an inherited IRA account and determined which type of beneficiary you are, you can begin to familiarize yourself with the specific tax implications that apply.
Tax Implications of Inheriting a Retirement Account Based on Whether or Not You're an Eligible Designated Beneficiary
Spouses as Eligible Designated Beneficiaries
If you rolled your spouse's retirement account into your own IRA account, you'll be taxed as follows:
You'll pay a 10% early withdrawal penalty if you take withdrawals before turning age 59 1/2.
After you reach your required minimum distribution* age, you'll be subject to your own RMDs based on your life expectancy.
If you rolled your spouse's funds into an inherited IRA account, you'll be taxed as follows on the RMDs.
If they were under RMD age: You'll pay your ordinary income tax rate for money withdrawn from the account before their RMD age. Then, you have until December 31st of the year in which your spouse would have received their RMD to take your first RMD.
If your spouse was taking their RMD: You have until December 31st of the year following their death to begin taking your first RMD.
*The IRS requires most owners of IRAs to begin taking RMDs by age 72, or 73 if you turn 72 after December 31, 2022. You'll be required to withdraw part of your retirement savings each year and pay ordinary income tax on it.
Non-Spouse Individuals Considered an Eligible Designated Beneficiary
Can take distributions over the longer of either their own life expectancy or the original owner’s remaining life expectancy, OR follow the 10-year post-death distribution rule (more on that below).
Distributions will taxed at their ordinary income tax rate.
Non-Eligible Designated Beneficiary
Must follow the 10-year post-death distribution rule and pay their ordinary income tax rate.
What if the Non-Eligible Designated Beneficiary Is a Trust?
For trusts other than a conduit trust, the retirement account funds must be withdrawn in full within five years (though they can remain within the trust).
However, if it's a conduit or "see-through" trust (you can "see" the individual beneficiaries), the IRS published a proposal to allow the IRA funds to be withdrawn following the more tax beneficial 10-year rule—at least for the time being.
From there, the trustee usually determines the amount to be distributed directly to the beneficiaries during the ten-year period, and the beneficiaries pay their ordinary income tax rate.
An accumulation trust that has stipulations for keeping the required distributions within the trust (versus distributing them directly to the individual beneficiaries), means the trust will pay taxes as follows in 2024.
10% for required distributions up to $3,100
24% for required distributions up to $11,150
35% for required distributions up to $15,200
37% for required distributions over $15,200
What’s the 10-Year Rule for Post-Death Required Distributions?
The IRS requires all non-eligible designated beneficiaries who inherit an IRA to withdraw the entire balance of the inherited IRA account by the end of the 10th year following the original owner's death.
The funds can be withdrawn at any point during the ten-year period, such as annually.
The penalty is steep for failing to meet this requirement: The IRS issues a 50% penalty on the remaining amount that should have been withdrawn if you miss this deadline.
What's the Rule for Inherited Roth IRA Accounts?
You're not required to take post-death required distributions or required minimum distributions when you inherit a Roth IRA. It offers tax-free distributions because the original account holder already paid taxes on their contributions (or conversions).
This can be a significant benefit, as it allows you to either keep the funds where they are if you don't need the money, or to withdraw the funds without incurring any additional tax liabilities.
These tax rules are complicated, so it's important to consult with a financial advisor and tax professional to determine the most efficient tax strategies for any withdrawals when you inherit retirement account assets.
Common Mistakes to Avoid When Inheriting a Retirement Account
Inheriting a retirement account comes with its own set of challenges, so it's important to avoid these common mistakes.
Failing to Take Post-Death Required Distributions Within 10 Years: If you're a non-eligible designated beneficiary, of the most common mistakes is failing to take the full post-death required distributions (in other words, liquidating the account) before the end of the 10th year after the person's death. Not doing so results in a 50% penalty on the remaining amount that should have been withdrawn.
Taking a Full Distribution Without Considering the Tax Implications: Taking the lump sum or a large distribution out of an inherited retirement account in a single year can push you into a higher tax bracket and result in a substantial tax bill.
Failing to Update Beneficiary Designations: When you inherit a retirement account and move it into your own account, it's crucial to update the beneficiary designations to reflect your own wishes. Failure to do so can result in unintended consequences and potentially costly mistakes for your beneficiaries.
Not Seeking Professional Guidance: It can be confusing to figure out the complex rules on eligible designated beneficiaries and distributions when inheriting a retirement account. That's why a professional's guidance can really help you out
Conclusion: Making Informed Decisions about Inherited Retirement Accounts
Losing a loved one is one of the most significant life experiences a person can face. It's emotional and there's so much to do get done. Inheriting a retirement account is just one of the many financial decisions you'll be faced with when you inherit assets from a loved one.
A financial advisor and tax professional can teach you the ins and outs of for each decision so you're more informed and comfortable with what to do. Find someone who will not only align your decisions with your financial goals, but who will help you honor the person who left the inheritance to you in the first place.
To learn more about what to do with an inheritance, you can book a free call with Life Story Financial. For more money and investment tips like these, check out our free ebook series and sign up for our monthly newsletter.
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