The emotional turmoil of losing a loved one can be overwhelming, and the added complexity of managing inherited retirement accounts like 401(k)s, IRAs, and Roth IRAs can make these times even more challenging. Each type of account comes with its own set of rules for withdrawing assets, and understanding these can help you make the most of your inheritance in a tax-efficient way. Here’s what to do when you inherit a retirement account.
Study Beneficiary Designation Forms
Unless the estate is named as the beneficiary or the participant fails to execute a beneficiary designation form, retirement accounts are considered non-probate assets. That simply means the transfer of these accounts is not dictated by the terms of a decedent’s will, but rather by a beneficiary designation form—a legal document specifying who receives benefits when a participant dies. For this reason, it’s crucial to routinely update beneficiary designations to reflect the decedent’s true wishes. Far too often, information becomes obsolete in the wake of marriages, divorces, births, and other lifechanging events that may alter who a decedent wants to inherit their assets.
The Power of Qualified Disclaimers
While the beneficiary designation form is the guiding document, what happens if the designated beneficiary is not the optimal choice? Although beneficiary designation forms can’t be altered after the participant’s death, primary beneficiaries who wish to reject their inheritance can execute a qualified disclaimer.1 Rooted in the Internal Revenue Code (IRC), this mechanism lets beneficiaries redirect assets to another individual, known as a “contingent beneficiary,” without triggering gift taxes or federal estate taxes. Keep in mind, the contingent beneficiary automatically becomes the next inheritor—the primary beneficiary cannot control who inherits in their place.
There are many reasons one might opt to use this estate planning tool. Perhaps a beneficiary already has substantial assets and would prefer their children or spouse enjoy the inheritance in their place. To execute a qualified disclaimer, the primary beneficiary must issue the request in writing and deliver it to the executor or trustee within nine months of the decedent’s death. During that time, that beneficiary may not receive any portion of those assets. More importantly, qualified disclaimers are irrevocable, where disclaimants will be treated as if they never received the gift in the first place.
Know Your Retirement Account Types
Whether it’s a traditional IRA, Roth IRA, or 401(k), each type of inherited retirement account carries distinct tax treatment rules. Consider the following implications:
Withdrawals from traditional IRAs and 401(k)s are generally taxed as ordinary income. This effectively means that the amount a beneficiary withdraws will supplement their taxable income for a given year, potentially lifting them into a higher tax bracket. On the other hand, withdrawals from Roth IRA and Roth 401(k) accounts are typically tax-free. This can be tremendously advantageous, especially if you anticipate graduating to a higher tax bracket in the future.
Special Considerations for Employer-Sponsored Plan
If you inherit an employer-sponsored plan like a 401(k), it’s important to determine whether the account contains appreciated employer securities. In these situations, you may have the option to withdraw the appreciated securities as a lump sum, with only the cost basis—the original purchase value of the shares—being subject to ordinary income tax rates. The net unrealized appreciation (NUA), which is the increase in value of the securities since their purchase, can be taxed at the more favorable capital gains rate when the shares are eventually sold. This approach can offer significant tax advantages.2
Minimum Distribution Requirements (RMDs)
Required minimum distributions (RMDs) are the sums of cash beneficiaries must annually withdraw from inherited IRAs and retirement plans, to avoid stiff tax consequences.3 Generally speaking, the timing and amount of RMDs depend on the beneficiary’s relationship to the deceased account holder and whether or not the account holder began taking RMDs before their death. If the account holder had already begun taking RMDs but died before completing the distribution in the year of their death, the remaining balance must be distributed to the beneficiary by the end of that year.
Click HERE for more information on the different types of beneficiaries and their RMD mandates.
Click HERE for more information on RMD timelines and deadlines.
Evaluate Withdrawal Options
For those inheriting a retirement account, it’s essential to assess your financial needs and tax situation when curating a withdrawal strategy—whether that involves a lump-sum payment, periodic distributions, or a stretch distribution. Here are some key points to consider:
- Design an Optimal Withdrawal Plan: Factor in your tax situation, the size of the inherited retirement accounts and your long-term financial goals. Strategies may include withdrawing funds from taxable accounts before accessing retirement accounts to maximize tax efficiency.
- Traditional Retirement Accounts: Lean into the tax-deferred growth potential of inherited traditional retirement accounts. Withdrawing funds too quickly can lead to adverse tax consequences. Beneficiaries should strive to let their assets grow in a tax-deferred manner for as long as possible.
- Eligible Designated Beneficiaries: In some cases, when a participant dies before their Required Beginning Date (RBD), an eligible designated beneficiary may benefit more from the 10-year rule (no annual distributions for 10 years) rather than the lifetime stretch.4
- Crafting a Tax-Efficient Withdrawal Strategy: Develop a withdrawal strategy that considers both maximum withdrawal rates and tax-efficient sequencing to minimize your overall tax burden.
- Managing Unrealized Capital Gains: Beneficiaries with significant unrealized capital gains in their taxable accounts may want to deplete inherited retirement accounts to preserve these taxable account assets for a potential step-up in cost basis when transferred to future heirs.
Inherited retirement accounts demand a clear understanding of tax implications, financial needs, and investment strategies. With careful planning and professional guidance, you can navigate the complexities of inherited retirement accounts and make the most of your financial legacy.
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
1 See IRC § 2518.
2 See IRC § 402(e)(4), Rev. Rul. 75-125, 1975-1 C.B. 254.
3 The penalty for missing a required minimum distribution (RMD) is a 25% excise tax on the amount not withdrawn. The penalty can be reduced to 10% if the RMD is corrected within two years.
4 Retirement plans may permit “some categories of” EDBs to elect to have the 10-year rule apply instead of the life expectancy payout. The deadline for this election is the year in which distributions would be required to begin under the life expectancy payout. The election becomes irrevocable and will apply to all subsequent beneficiaries. See Reg. § 1.401(a)(9)-3(c)(5)(iii).