Inheriting money is not a thing most people benefit from more than once or twice in a lifetime, if at all. For the vast majority of individuals, these funds are free of estate tax, because the law only taxes estates worth more than several million dollars. However, the money you inherit from a traditional retirement plan (401k or IRA) differs from other assets, as you are taxed on money that you withdraw from these plans.
How It Works with an IRA
An individual saves money during their working lives in a traditional IRA or 401k, where it grows free of tax. When that person reaches the age of 70 years and six months of age, they must take out that money and pay tax on the withdrawals. These are termed required minimum distributions (RMDs).
The idea behind it is to save money while working, then withdraw that money when you retire. However, if a person passes away and money is left in their IRA or 401k, the named beneficiary inherits the funds in the account. A will or a trust does not direct the distribution of retirement accounts. Retirement accounts go to the beneficiary named on the plan’s documents. If no beneficiary is named, then those assets typically pass to the decedent’s estate.
Two sets of rules exist for inheriting retirement assets. There is one for surviving spouses and another for everyone else. These rules can be complicated and overwhelming. An estate planning attorney can help you navigate them. Or, the plan’s administrator may be able to guide you through your options.
How you withdraw money from your Inherited IRA can vary, with the following options:
- You can take the whole thing out and pay the required tax on that withdrawal.
- You can choose to take out a specific amount each year.
- You can take advantage of “stretch out” planning, which allows you to stretch out your withdrawals over your lifetime.
Many estate planners recommend stretch out planning because the account continues to grow tax-free and small, annual withdrawals have a less dramatic effect on your personal yearly income taxes. If you need to take more money out in any given year, you can also do that. An Inherited IRA has a minimum required distribution but no maximum distribution.
How It Works with a 401k
Inheriting assets from a 401k is very similar to what is outlined above. If you are the spouse of the deceased, you can roll that account into an IRA. If you are not the spouse, you can still transfer the assets from a 401k into an Inherited IRA. Some specific 401k plans may allow the deceased person’s assets to remain in the plan as an inherited account and include stretch out provisions, but others do not. When no stretch out plan is available, you could either withdraw all the funds from the 401k within five years or convert the account into an Inherited IRA.
Roth Plan Assets
Roth IRA’s and Roth 401ks are different. Roth plan assets are not subject to tax upon withdrawal, as long as the Roth has been open for five or more years.
An experienced estate planning attorney, like an estate planning attorney, can provide clarity and discuss your options with you. Contact one in your area today to get the information you need.