What to do after inheriting a retirement account from a parent or relative

Updated in 2020. If you have just inherited a retirement account like an IRA or 401(k) from a parent, sibling, or relative, you may be unsure about what your options are and what to do next. As a non-spouse beneficiary, you likely will need to take the money in 10 years. For more information on what to do after receiving an inheritance, contact us today to schedule a consultation.

Starting in 2020, under the Secure Act, beneficiaries who inherit a retirement account from a non-spouse (e.g. a parent or relative) can no longer ‘stretch’ the distributions over their lifetime by taking required minimum distributions (RMDs). Instead, they must to take the funds in 10 years. The change won’t impact anyone who inherited a retirement account during 2019 or years prior.

Inheriting a retirement account from a parent, grandparent, sibling, or relative

If you’ve inherited a retirement account from a parent, the primary decision is when to take the money. Under the new rules which began in January 2020, these inheritances must be distributed by the end of the 10th year following the year your parent or relative passed away. You might decide to take your inheritance all at once right away, delay until the last year, or spread it evenly over 10 years.

Opening an inherited IRA

When you inherit a retirement account from a parent, you’ll need to open an inherited IRA. This account will hold your inheritance until you take the money out. You can open an inherited IRA at the financial institution of your choosing. If you’re working with a fee-only financial advisor, they can help you coordinate this process.

Tax treatment of an inherited retirement account

Most retirement accounts are funded with pre-tax dollars so distributions are fully taxable to you, the beneficiary, as regular income. Accordingly, if you’ve inherited a large account, consider working with your financial and tax advisor to develop a strategy to minimize taxes on distributions and ensure the approach aligns with the rest of your financial situation.

The rules for inherited Roth IRAs are a bit different. If it’s been at least five years since the original account owner first funded the Roth IRA, distributions will be tax-free. The funds still need to be withdrawn by the end of the 10th year.

If the decedent made after-tax non-Roth contributions to an IRA, you’ll need to find the records to prove it to exclude the appropriate amounts from your taxable income.

Who doesn’t have to take their inherited retirement account in 10 years?

There are three exceptions to the 10-year rule. Minor beneficiaries have until the age of majority (age 18 to 21 by state) before the clock starts on the 10-year period. The 10-year rule doesn’t apply to disabled beneficiaries or those less than 10 years younger than the decedent. These beneficiaries could withdraw the funds over their lifetime using the pre-2020 required minimum distribution rules for inherited retirement accounts.

Read: Inheriting a Trust Fund: Distributions to Beneficiaries

Planning strategies for your inheritance

If you’ve inherited a significant amount of money in a retirement account, you’ll need to work with your tax and financial advisor. It’s important to develop a plan to avoid negative tax consequences and take advantage of tax-saving opportunities. For example, if you are on the cusp of retiring or moving to a more tax-friendly state, consider holding off on withdrawals until your state and federal income tax rate is lower. If you are about to retire, keep in mind Medicare premiums are based on income, too.

On the other hand, if you plan to apply for financial aid for college, you might want to avoid large increases to your income that would be reported on your FAFSA. (The FAFSA uses the prior, prior year’s tax returns)

Even if you don’t have any major events on the horizon, it still makes sense to do additional planning to balance the benefits of continued tax-deferred growth with the downsides of triggering the 3.8% Medicare surtax or loss of other tax deductions due to income. Non-spouse beneficiaries cannot convert an inherited retirement account to a Roth IRA.

Reinvesting your inheritance: After-tax proceeds can be reinvested in a brokerage account and used down the road for long-term financial goals. Keeping the funds invested helps curb increases in lifestyle spending. This is most tempting when funds are highly visible or sitting in a checking or savings account.

For more information on what to do after receiving an inheritance, contact us today to schedule a consultation.

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Inherited an IRA or other type of retirement account?You may have a lot of questions, Our guide can help walk you through your options.