Inheriting money is not something most of us do more than once or twice in a lifetime, if ever. For the vast majority of us, this money comes to us free of estate tax, because current law only taxes estates worth more than $10 million, indexed each year for inflation.
But money that you inherit from a traditional retirement plan (IRA or 401k) is different from other assets, because you will be taxed on the money that you withdraw from these plans. For many of us, that’s the main tax consequence of inheriting at all.
Here’s how it works. In a traditional IRA or 401k, a person saves money during their working lives, where it grows free of tax. When a person reaches the age of 70 and ½, they have to start taking out that money and paying tax on those withdrawals, called minimum required distributions, or RMDs. The idea is that they saved that money while working (and paying a higher income tax rate on those earnings) but can withdraw that money when they’ve retired (and are presumably now at a lower income tax bracket). If a person dies, though, and there’s money left in that IRA or 401k, the named beneficiary inherits the account. It is important to know that a will or a trust does not govern the distribution of retirement accounts – these accounts go to the beneficiary named on the plan’s forms. If no one is named, then those assets usually pass to the decedent’s estate, which, if the account is big enough, could trigger a probate.
There are two sets of rules for inheriting retirement assets: one for surviving spouses and one for everyone else. These rules are complicated and can feel bewildering. But when you are actually named as a beneficiary of a retirement plan, the plan’s administrator will guide you through the choices available.
Let’s say that your Uncle Joseph died. For our purposes, he was 62 when he died, so hadn’t begun taking money out of his IRA. If he named his wife, Sonia, as the beneficiary of his IRA, she will be able to roll that inherited IRA into her own individual IRA, and she won’t have to start taking money out until she is 70 and ½. She could also choose to keep the money in Joseph’s account, but most people do the rollover, unless they have an immediate need for the money, in which case keeping it as Inherited IRA is a better choice. If Sonia is 60, she can wait another 11 years before she must begin to withdraw money from that account. In the meantime, it can continue to grow free of tax and she can continue to make contributions to it. (If Joseph had died after he turned 70 ½, these rules would be slightly different.)
But if your Uncle Joseph died and unmarried man and left you, his beloved niece or nephew, his IRA, you will inherit what’s called an Inherited IRA, with a different set of rules. First, you can’t add any more money to that account. Second, you have to withdraw the money in that account starting in the year after Joseph died. Any money you withdraw is subject to income tax at your individual rate. If you don’t take out these required distributions, the IRS will impose a fifty percent tax penalty on the amount that’s not withdrawn.
Third, you have three choices, under current law, as to how you can withdraw the money in your Inherited IRA:
- You could just take the whole thing out and pay tax on that withdrawal.
- If Uncle Joseph hadn’t started taking out RMD’s, you could keep the money in that account for up to five years.
- You can take out a small amount each year, based on your life expectancy, defined by the IRS in special tables.
That last option is called ‘stretch-out’ planning because it allows you to stretch out your withdrawals over your entire lifetime. (There’s a new law, called the Secure Act, that has passed the House, that would limit this stretch-out to 10 years, but it hasn’t been voted on by the Senate, or signed by the President.) Most financial planners recommend doing stretch-out planning because it allows you to let the account continue to grow tax free and smaller, annual withdrawals will have a less drastic effect on your income taxes each year. If you want to take more money out in a given year, you can do that as well, an Inherited IRA only has a minimum required distribution, there’s no maximum distribution.
Here’s an example: if you have inherited an IRA worth $100,000 from Uncle Joseph, and you are 43 years old, the IRS tables say you have a life expectancy of 43.6 more years. Dividing $100,000 by 43.6 you get $2,294, so that’s how much you’d be required to withdraw from the account at the end of the year. Each year after that, you’d subtract 1 from the life expectancy used the previous year to calculate your RMD, so next year you’d use 42.6. But, actually, the plan administrator will tell you what the RMD is, you don’t have to calculate that yourself. If you need to take more money out, you can do so, but you’ll be taxed on that withdrawal, and if you take out a big chunk of cash, it could push you into a higher tax bracket as well.
Inheriting assets from a 401k is similar to what I’ve outlined above. If you are a spouse, you have the option of rolling that account over into an IRA. If you are not the spouse, you can transfer the assets from the 401k into an Inherited IRA. Some 401k plans allow the deceased person’s assets to stay in the plan as an inherited account and include stretchout provisions, but many do not. When no stretch out planning is available, you would either have to withdraw the entire account within five years from that 401k, or convert that account into an Inherited IRA.
Roth IRA’s and Roth 401ks are different. Generally speaking, if you are a spouse, you can delay distributions until the time when the deceased IRA owner would have been 70 ½ or treat the Roth IRA as your own. If you are a non-spouse beneficiary, you will have to withdraw the assets in that inherited Roth IRA within five years. But, because these are Roth plans, these assets are not subject to tax upon withdrawal, as long as the Roth has been open five years or more.