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:
- You can take all the money out and pay tax on the withdrawal.
- If Uncle Joseph hadn’t started taking out RMD’s, you can leave the money in the 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 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.
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.lizahanks.com. A version of this article originally appeared on her blog.