What to do after inheriting a retirement account from a parent or relative
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.
Important planning notes: The IRS has proposed changes to previous guidance regarding RMDs during the 10-year window. As drafted in 2022, the IRS’ changes would impact certain non-spouse beneficiaries by requiring distributions in years 1 to 9 in addition to withdrawing all the funds in year 10 if the decedent was subject to RMDs when they died.
In July 2023, the IRS released a notice extending the penalty waiver on missed distributions for 2023 (if missed solely due to pending guidance) and indicated that final guidance won’t come until 2024.
Because the changes are not yet finalized, this article is written under the existing assumptions which do not require RMDs during the 10-year window.
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.
The Secure Act created two classes of designated non-spouse beneficiaries: eligible designated beneficiaries (not subject to the 10-year rule) and non-eligible designated beneficiaries. This article focuses on the distribution rules for non-eligible designated beneficiaries as that is most common.
Inheriting a retirement account from a parent, grandparent, sibling, or relative
Based on widespread interpretation of the Secure Act, when a decedent dies after January 1st, 2020, a non-spouse beneficiary (non-eligible designated beneficiary) must empty the retirement account by the end of the 10th year following the year of death. Under this interpretation, there would be no RMDs during this period, though voluntary withdrawals are still allowed.
In early 2022, the IRS issued proposed guidance that would change this guidance for certain heirs. As drafted, the changes would impact non-eligible designated beneficiaries by requiring distributions in years one through nine in addition to withdrawing all the funds in year 10, if the decedent was subject to RMDs when they died. Distributions during the 10-yearwindow would generally be based on the beneficiary’s own single life expectancy according to the the IRS’ Uniform Lifetime Table reduced by one each year.
Currently, beneficiaries who inherited a retirement account from a non-spouse who died before reaching their required beginning date (also called RMD age) would only need to empty the account in 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 401(k) or IRA, 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 are still subject to the 10-year rule.
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?
A non-spouse eligible designated beneficiary includes minor children of the account owner until age 21, disabled or chronically ill individuals, and individuals not more than 10 years younger than the account owner.
Planning strategies for your inheritance
If you’ve inherited a significant amount of money in a retirement account, consider your options carefully. 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. 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.
Last updated 7/19/2023