Many people will inherit an individual retirement account (IRA) or 401(k) and wonder how to incorporate this inheritance into their finances. The next move is not only critical, but it's also time-sensitive if you want to avoid a taxable event. Your options will vary, depending on whether you are the spouse of the account holder.
- A spouse who inherits a lump sum can take all of the assets at once, transfer the assets to their IRA, or open an inherited IRA.
- You have to take minimum distributions from the IRA by the end of the year your spouse died, or the year they would have turned 70 1/2.
- Children and non-spouses can choose an inherited IRA or lump sum but must still take required minimum distributions if the inherited IRA is chosen.
How You Inherit an IRA or 401(k)
Those who inherit an IRA or 401(k) are known as "designated beneficiaries" of an account. When an individual first opens an IRA or 401(k) plan, part of the initial paperwork process is to name at least one primary and maybe even some contingent beneficiaries. On the death of the account holder, the assets in the account are passed along to the beneficiaries in the way that the account holder pre-determined in the initial paperwork.
If you don’t remember the beneficiaries you named to your own account, you can always check with the company that administers your plan. Many 401(k) and IRA providers allow you to do that online. For example, take Kelly, who has a husband and two children. Her husband is the primary beneficiary of 100% of her IRA funds, and her two kids are each 50% contingent beneficiaries. This means that, upon Kelly’s death, her husband inherits the full account. If he is not alive to inherit the assets or passes on while receiving distributions from the account, the assets will be divided between the children. There are many ways to divide assets between or among beneficiaries, and it's possible to name a trust or estate as beneficiary or contingent beneficiary of an IRA or 401(k).
Inherited IRA or 401(k) Options for a Spouse
If you are a spouse, you have the most options when inheriting a 401(k) or an IRA. The first option, and possibly first instinct when dealing with an IRA or 401(k) that has been inherited, is to take the assets out all at once, which is known as a "lump sum distribution." With that option, you pay taxes on the distributed money.
The lump sum must be included as part of your annual income when reporting taxes for that year. There may even be a mandatory 20% withholding for taxes when the money is taken out. The good news is the assets will not be subject to the typical 10% early withdrawal penalty imposed on the creator of the account.
Some spouses may instead want to keep the money growing tax-deferred for their own retirement. A spouse has the unique ability to transfer assets to their own IRA. However, non-spouse beneficiaries cannot take that option. The withdrawal schedule and penalties for early withdrawal will fall under the typical IRA withdrawal rules.
The third option for a spouse is to open something called an "inherited IRA." Such an account would remain in Kelly's name for the benefit of her husband. Just like with the other IRA option, the assets would continue to grow tax-deferred until the money were withdrawn. The difference with this IRA option is the funds can be accessed at any time.
Rules for Distribution
There are some very strict rules on when heirs must begin taking distributions. A required minimum distribution (RMD) is the amount that must be taken from the account each year during retirement, based on the age of the account holder or beneficiary, and size of the account. (You can divide your account balance for the prior year by life expectancy to calculate your RMD.)
If Kelly were younger than 70 1/2 when she died, her husband would have to start taking annual required minimum distributions by either the end of the year of her death or the end of the year in which she would have turned 70 1/2, whichever date is later.
If Kelly were older than 70 1/2 at the time of her death, her husband would have to take the annual RMD by the end of the year following Kelly’s death. The exception is if Kelly were taking distributions at the time of her death. In that case, her husband would have to take the RMD in the year of Kelly’s death. If the account were a 401(k), the RMD may be required before the assets could be moved into a new IRA.
Options for Children and Non-Spouses
If the IRA you inherit is from a parent or other non-spouse, you do not have the option to roll the account directly into your own. However, you can set up an inherited IRA and have the assets continue to grow, tax-deferred. Again, this account remains in the name of the original account holder for your benefit.
The RMDs are the same. If the holder of your account passed away before age 70 1/2, you must take RMDs either by the end of that year or the end of the year in which the account holder would have turned 70 1/2, whichever is later.
Non-spouses also have the right to cash out, pay the taxes, and take the lump sum. When there is more than one beneficiary, you can request to split the account and let each beneficiary decide what to do with their share.
Whatever choice you make has its impact. Before deciding which option is best for you, it may help to speak to a tax advisor as well as a financial planner to get a full view of how each affects your financial picture. Even a representative at the IRA fund company or 401(k) administrator may be able to walk you through your options.