What to Do When You Inherit an IRA or 401k

Have you inher­ited an IRA or 401k plan? Estate plan­ning expert Liza Hanks tells you what rules apply and what to do next.

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 taxes only estates worth more than $10 mil­lion, indexed each year for inflation.

But money that you inherit from an IRA or 401k is dif­fer­ent, because you’ll pay taxes on money you with­draw. For many of us, that’s the main tax con­se­quence of inher­it­ing at all.

How Tra­di­tional IRAs and 401ks Work

In a tra­di­tional IRA or 401k, a per­son saves money dur­ing their work­ing lives, where it grows free of tax. At the age of 70 ½, they have to start tak­ing out that money and pay­ing tax on those with­drawals. (These with­drawals are 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 there’s money left in an IRA or 401k when the per­son dies, the named ben­e­fi­ciary inher­its the account.  Wills and trusts don’t gov­ern the dis­tri­b­u­tion of retire­ment accounts; they go to the ben­e­fi­ciary named on the plan’s paper­work. If the account holder does­n’t name any­one, the account usu­ally passes to their estate when they die, per­haps trig­ger­ing a pro­bate pro­ceed­ing. (Nam­ing a ben­e­fi­ciary for a retire­ment account is one of the eas­i­est ways to avoid pro­bate.)

Rules for Inher­it­ing an IRA or 401k

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 inherit a retire­ment plan, the plan’s admin­is­tra­tor will guide you through your choices. For the pur­poses of this arti­cle, the eas­i­est way to explain the rules is to look at an example.

Let’s say your Uncle Joseph died at 62, so hadn’t begun tak­ing money out of his IRA. If Joseph named his wife, Sonia, as the ben­e­fi­ciary of his IRA, she will be able to roll that inher­ited IRA into her own indi­vid­ual IRA. Then she won’t have to start tak­ing money out until she is 70 ½.  Sonia 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. Until Sonia reaches 70 1/​2, her IRA, includ­ing the inher­ited money, can con­tinue to grow free of tax. She can also con­tinue to make con­tri­bu­tions to it. (If Joseph had died after he turned 70 ½, these rules would be slightly different.)

But if Uncle Joseph left you, his beloved niece or nephew, his IRA, you’ll face a dif­fer­ent set of rules. First, you can’t add any more money to that account. Sec­ond, you have to with­draw the money start­ing the year after Joseph died. And the money you with­draw is sub­ject to income tax at your indi­vid­ual rate. If you don’t take these required dis­tri­b­u­tions, the IRS imposes a fifty per­cent tax penalty on the amount you don’t withdraw.

How to With­draw Money From an Inher­ited IRA

Con­tin­u­ing the exam­ple above, cur­rent law gives you three choices for with­draw­ing money from an Inher­ited IRA:

1. You can take all the money out and pay tax on the withdrawal.
2. If Uncle Joseph hadn’t started tak­ing out RMD’s, you can leave the money in the account for up to five years.
3. 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 extend your with­drawals over your entire life­time. (There’s a new law, called the Secure Act, that has passed the House, that would limit the stretch-​out to ten years, but the Sen­ate has­n’t yet voted on it.) Most finan­cial plan­ners rec­om­mend doing stretch-​out plan­ning because:

• the account con­tin­ues to grow tax free, and
• smaller, annual with­drawals will have a less dras­tic effect on your income taxes each year.

But 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.

Return­ing to our exam­ple: If you’ve 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 one year 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, too.

With­draw­ing Money From Inher­ited 401k Plans and Roth IRAs

Inher­it­ing assets from a 401k is sim­i­lar to what I’ve out­lined above. If you are a spouse, you can roll the 401k over into your IRA. If you are not the spouse, you can con­vert 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 stretch-​out 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 IRAs 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 not the spouse, you must 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.

More Infor­ma­tion

For the lat­est infor­ma­tion on estate taxes and other inher­i­tance laws, see What’s New for 2019 for Fed­eral and State Estate, Inher­i­tance, and Gift Tax Law. To learn more about your state’s rules, see Does Your State Col­lect an Inher­i­tance Tax? in Legal Con­sumer’s Inher­i­tance Law learn­ing cen­ter.

For more about pro­bate and how to avoid it, see What Is Pro­bate and How Does It Work?

Liza Han­ks’s most recent book is Every Cal­i­for­ni­an’s Guide to Estate Plan­ning. To con­nect with her directly, visit www​.liza​hanks​.com. A ver­sion of this arti­cle orig­i­nally appeared on her blog.