How Do You Inherit an IRA or 401(k)?
Those who inherit an IRA or 401(k) are the “designated beneficiaries” of an account. When an individual first opens an IRA or a 401(k) plan, part of the initial paperwork process is to name at least one primary and maybe even some contingent beneficiaries. When the account holder dies, the assets in the account are passed to these beneficiaries in the way that the account holder predetermined in the initial paperwork. For example, an account holder might have a spouse and two children. Their spouse is the primary beneficiary of 100% of the IRA funds. Their two kids are each 50% contingent beneficiaries. This means that the spouse would inherit the full account upon the account holder’s death. The assets would be divided between the children if the spouse were not alive to inherit or if they pass while receiving distributions from the account.
Inherited IRA or 401(k) Options for a Spouse
You have the most options when inheriting a 401(k) or an IRA if you’re the spouse of the account holder. The first option, and possibly an individual’s first instinct when dealing with an IRA or 401(k) that’s been inherited, is to take the assets out all at once. This is known as a “lump sum distribution.” The lump sum must be included as part of your annual income when you’re reporting on your tax return 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 won’t be subject to the typical 10% early withdrawal penalty that’s normally 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, but non-spouse beneficiaries can’t take this 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 an “inherited IRA.” This type of account would remain in the original owner’s name for the benefit of their spouse. Just as with the other IRA option, the assets would continue to grow tax deferred until the money is withdrawn. The difference with this IRA option is that the funds can be accessed at any time.
Rules for Distribution
There are some very strict rules regarding 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 on the size of the account. If the account holder was younger than age 70½ when they died, their spouse would have to begin taking annual required minimum distributions 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 date is later. If the account holder was older than age 70½ at the time of their death, their spouse would have to take the annual RMD by the end of the year following the death. The exception is if the account holder was taking distributions at the time of their death. Their spouse would have to take the RMD in the year of their death in this case.
Options for Children and Non-Spouses
You don’t have the option to roll the account directly into your own if the IRA you inherit is from a parent or other non-spouse. But you can set up an inherited IRA and have the assets continue to grow tax deferred. Again, the account remains in the name of the original account holder for your benefit. The RMDs are the same. 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 70½, whichever is later, if the holder of your account passed away before age 70½. 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 before deciding which option is best for you. Even a representative at the IRA fund company or a 401(k) administrator may be able to walk you through your options.
