Hello, I just found out I am the beneficiary of my late uncle’s large 401(k) and IRA. What can I do to avoid taxes now on my new inheritance? – Anonymous Reader
You have two main options after inheriting a retirement account. Withdraw all of the money and receive a whopping tax bill, or move the inherited 401(k) or IRA into a Beneficiary IRA (aka Inherited IRA) and defer taxes until you make withdrawals. There are some rules that need to be followed if you want to go the Inherited IRA route.
There are no minimum age requirements when it comes to cashing out an inherited retirement account. The 10% early withdrawal penalty that would be levied if you pulled money from your own retirement account before the age of 59 ½ does not apply. However, you will still be liable for income taxes on the money you withdraw. For a larger IRA, that could mean paying taxes at a much higher rate if you withdrew all of the money at once versus over time.
Inherited IRA Deadlines for Non-Spouse Beneficiaries
Tax deadlines may be the last thing on your mind after the passing of a loved one. But if you want to make the most of your inheritance and minimize taxes, you must know the various dates and deadlines to follow. Required minimum distributions (RMDs) from the account will be required by December 31st of the year after the IRA or 401(k) owner passes so you do have some time to get professional guidance on this topic. If RMDs are not started then the beneficiary must close the account within five years of the date of death.
If you chose to follow the RMD schedule, you would be allowed to remove money over a much longer period of time. Withdrawals would be based on your own life expectancy, each year, starting no later than December 31st of the year after your loved one passed. Distributions are similar to the RMDs that you would be required to take on your personal retirement account, but they use a different life expectancy table.
Spouses Who Inherit IRAs or Other Retirement Accounts
When spouses inherit IRAs, they have a third option unavailable to non-spouse beneficiaries. They can rollover the account into a retirement account in their names. Doing so exempts them from RMDs until they reach the age of 70 ½. The main downside to that strategy is that withdrawals before 59 ½ will be subject to the 10% early withdrawal penalty. That is not a big issue if you do not plan or expect to touch the money, or if you are already above this age.
If surviving spouses anticipate needing some of the money from those retirement assets before 59 ½, they may want to consider moving some of the funds into an Inherited IRA to avoid the 10% early withdrawal penalty on money taken from the account. Then move the rest into an IRA in their own name.
Exception If the Deceased Was Already Taking RMDs
If the original IRA owner was taking RMDs, the beneficiary can decide whether to continue the annual withdrawals based on the decedent’s RMD schedule or their own life expectancy.
Which option should you choose? That will depend on your need to access the funds. If the goal is to put off taxes as long as possible, you should use the life expectancy of the youngest person, living or not. If the older spouse is the survivor / beneficiary, it may make sense for that person to continue receiving withdrawals based on the deceased’s life expectancy.
Rule When Inheriting a Roth IRA
The rules are different for owning and contributing to a Roth IRA versus a Traditional IRA or 401(k) plan. It should come as no surprise that there are also different rules for an inherited Roth IRA. Luckily, a Roth IRA can typically be inherited tax-free. But unlike your own Roth IRA, you will not be allowed to keep money in an inherited Roth IRA forever. Non-spouse beneficiaries will be required to make distributions each year based on their own life expectancy. That requirement starts the year after the original owner’s passing.
Spousal beneficiaries have the option to rollover the inherited Roth IRA into a Roth IRA account in their own names. They will not be forced to take RMDs. They will also have the option to just pull all the money out tax-free.
That being said, you will be better off leaving the money in the Roth IRA, growing tax-free, versus outside in the taxable environment.
Five Inherited IRA Mistakes
I previously wrote about five inherited IRA mistakes that could destroy your windfall. If you are the beneficiary of an IRA, it is worth taking a few minutes to read the post. The expensive mistakes may seem silly, but they are irreversible and quite easy to make.
See IRS Publication 590, “Individual Retirement Arrangements”, for more information about the fine print, as well as the life expectancy table for required withdrawals.
A trusted financial planner can be your guide through a difficult time after a loved one passed. That person can also help you make the most of your inheritance, in addition to things like minimizing taxes and planning for the future. If nothing else, a trusted financial planner can help take some of the stress out of all the choices you are forced to make when you least want to think about anything financial.