When a person inherits a retirement account, the next step is critical and requires immediate attention if you want to avoid a taxable event. The options available to you will depend on whether you are the spouse of the account holder or not.
How to Inherit an IRA or 401(k)?
Individuals who inherit an IRA or 401(k) are the “designated beneficiaries” of the account. When a person opens a retirement account for the first time, they must name primary beneficiaries and possibly some alternate beneficiaries in the initial paperwork. Upon the account holder’s death, the assets in the account are passed on to these beneficiaries in the manner specified by the account holder in the initial paperwork.
Inherited IRA or 401(k) Options for Spouses
You have the most options when you inherit a 401(k) or IRA if you are the spouse of the account holder. The first option, and perhaps the instinctual first reaction when dealing with an inherited IRA or 401(k), is to withdraw all the assets in one lump sum. This is known as a “total distribution.”
The total amount must be included as part of your annual income when you file your tax return for that year. There may even be 20% in mandatory withholding taxes when withdrawing the funds. The good news is that the assets will not be subject to the usual early withdrawal penalty typically imposed on the account holder.
Some spouses may instead wish to keep the growth of the funds tax-deferred for their own retirement. The spouse has the unique ability to transfer the assets into their own IRA, but non-spousal beneficiaries cannot take this option. The withdrawal schedule and penalties for early withdrawal will be subject to the normal IRA withdrawal rules.
The third option for the spouse is to open an “Inherited IRA.” These accounts will remain in the name of the original owner for the benefit of the spouse. Just like the other IRA option, the assets will continue to grow tax-deferred until the funds are withdrawn. The difference in this option is that the funds can be accessed at any time.
Distribution Rules
There are some strict rules about when heirs must start taking distributions. The 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 the account size.
If the account holder is younger than 70½ at the time of death, the spouse must begin taking the required minimum distributions annually either by the end of the year of the account holder’s death or by the end of the year in which they would have turned 70½, whichever is later.
If the account holder is older than 70½ at the time of death, the spouse must take the required annual distribution by the end of the year following the death. The exception is if the account holder was taking distributions at the time of death. In this case, the spouse must take the required annual distribution in the year of the death.
It may be necessary to take the required minimum distribution before the assets are transferred to a new IRA if the account is a 401(k).
Options for Children and Non-Spouses
You do not have the option to transfer the account directly to your own account if the IRA you inherit is from your parents or is non-spousal. However, you can set up an Inherited IRA and allow the assets to continue to grow tax-deferred. Again, the account remains in the original name of the account holder for your benefit.
The required minimum distributions are the same. You must take the required minimum distributions either by the end of that year or by the end of the year in which the account holder would have turned 70½, whichever is later, if your account holder died before age 70½.
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Talking to a tax consultant as well as a financial planner helps get a complete view of how each option will affect your financial picture before making a decision about which option is best for you. Even a representative at an IRA fund company or a 401(k) administrator may be able to assist you in exploring the options available to you.
Frequently Asked Questions
Who is entitled to decide what happens to the account if there are multiple beneficiaries who are not spouses?
Non-spouses also have the right to withdraw funds, pay taxes, and take distributions of the total amount. You can request to split the account and allow each beneficiary to make a decision regarding their share if there is more than one beneficiary.
What happens if the account holder does not name a specific beneficiary?
It is possible to name a living trust or estate as a beneficiary or alternative beneficiary for an IRA or 401(k). The assets will automatically go to the estate if no beneficiary is named, and they must be distributed within less than five years in this case, according to IRS rules.
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Source: https://www.thebalancemoney.com/what-to-do-with-an-inherited-ira-or-401-k-2894518
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