Tax Consequences Of Inheriting an IRA If You're a Surviving Spouse

Tax consequences depend on the beneficiary's relationship to the deceased

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A family member or anyone else can take control of an IRA or 401(k) after a loved one has died simply by presenting her original death certificate to the bank or other financial institution where the account is held. The only requirement is that he be named as beneficiary.

But inheriting this type of account can come with tax consequences. The results can be very different depending upon how and if the beneficiary is related to the deceased. A surviving spouse has a great deal of flexibility as to what he can do with an inherited IRA or 401(k).

Roll It Over

The surviving spouse can simply elect to roll the IRA or 401(k) over into her own retirement account. All the deferred income taxes associated with the IRA or 401(k) will continue to be deferred until the surviving spouse makes withdrawals from his account.

The surviving spouse can also use his own life expectancy for taking required minimum distributions (RMDs). He can choose who will receive the account at the time of his own death, naming his own beneficiary.

Leave the Account Alone

The surviving spouse can continue to treat the account as the deceased spouse's account.

The benefits of this type of election work in the limited situation where the first spouse dies well before the age of 70 1/2—the time when she would have to have begun taking RMDs—and the surviving spouse is under the age of 59 1/2. He would be hit with a 10% tax penalty if he were to begin taking withdrawals before this age.

Leaving the account as is allows the surviving spouse to defer taking RMDs until the deceased spouse would have been required to do so. He can then take distributions from the account without incurring the 10% early withdrawal penalty. Then he can then roll the account over into his own retirement account when he reaches age 59 1/2.

The surviving spouse can choose who will receive the account if he dies before reaching 59 1/2.

Fund the Account into an A or B Trust

The surviving spouse can also fund the retirement account into an A or B trust if one was established in the deceased spouse's estate plan prior to her death. This can occur with a beneficiary designation or a disclaimer by the surviving spouse.

The income taxes will still be deferred until the surviving spouse makes a withdrawal from the account if the IRA or 401(k) becomes a part of the deceased spouse's trust. The surviving spouse will be required to start taking RMDs calculated over his life expectancy after the account becomes part of the trust.

The surviving spouse won't be able to change the beneficiary of the account after the surviving spouse dies.

Estate Tax Consequences for Surviving Spouses

Spouses can leave assets to each other at death free from estate taxes due to the unlimited marital deduction, but 100% of the fair market value of the IRA or 401(k) as of the date of the surviving spouse's death would be included in his own estate for estate tax purposes if he were to roll it over into his own account.

The value of the IRA or 401(k) would not be included in the surviving spouse's estate if it were funded into a B trust, however.

An exception to this rule exists if he were to remarry and name his current spouse as the account's beneficiary. Again, the unlimited marital deduction would apply.

If You're Not the Surviving Spouse

The income tax consequences of inheriting the account will depend on what you choose to do with it if you're not the surviving spouse of the account owner. You have two basic options.

  • Transfer the account into an inherited IRA: You'll be required to begin taking RMDs by December 31 of the year following the deceased owner's death if you elect this option. The distributions will be calculated over your own life expectancy. You can also take out additional amounts as needed. The amount of the distribution would be included in your taxable income in each year a distribution is taken.
  • Cash out the account in full: The entirety of your distribution will be included in your taxable income if you choose this option.

Estate Tax Consequences for Non-Spouse Beneficiaries

The entire fair market value of the IRA or 401(k) will be included in the value of the deceased owner's estate for estate tax purposes if the account is left to anyone other than a surviving spouse. The deceased owner's estate will owe estate taxes if the total value of all her assets, combined with the value of the IRA or 401(k), exceeds the current federal or state estate tax exemption.

As of 2019, the federal estate tax exemption is set at $11.4 million, so this might not be a concern for most taxpayers. Estates must only pay taxes on values over and above this threshold.

When the IRA or 401(k) Is Needed to Pay Estate Taxes

It can pose a problem for the beneficiary of the IRA or 401(k) if the deceased owner's estate is taxable and there aren't enough assets outside of the IRA or 401(k) to pay the estate tax bill. But again, this only applies to very valuable estates because of the $11.4 million exemption.

Each withdrawal from an IRA or 401(k) would result in the amount being included in the beneficiary's taxable income. It would result in more income taxes if the beneficiary needs to take additional cash out of the account to pay an estate tax bill. The final result can be financially devastating to your loved ones, from 50% to nearly 90% of the retirement account lost to estate and income taxes.

The only way to avoid this is to ensure that your estate has enough cash or other liquid assets outside the retirement account to pay the estate tax bill—unless, of course, you leave the account to your surviving spouse, but this defers rather than eliminates any estate tax burden.