Managing the Tax Consequences of Inheriting Retirement AccountsDecember 17, 2024

Tax Implications of Inherited Retirement Accounts

When inheriting retirement accounts, understanding the tax rules and implications is essential for maximizing the value of the inheritance. Different types of retirement accounts—traditional IRAs, Roth IRAs, 401(k)s, and others—have specific tax implications depending on who inherits the account and the options they choose for distributions. This guide outlines the major tax rules, distribution choices, and strategies that can help beneficiaries manage inherited accounts effectively and minimize tax liability.

Understanding Inherited Retirement Accounts

What Is an Inherited Retirement Account?

An inherited retirement account is a retirement savings account passed down to a beneficiary after the account holder’s death. Inherited accounts include traditional IRAs, Roth IRAs, 401(k)s, 403(b)s, and other employer-sponsored retirement plans. The tax treatment of these accounts differs depending on the type of retirement account and the relationship between the deceased and the beneficiary. Beneficiaries must understand the tax implications and follow required distribution rules to avoid penalties.

Types of Beneficiaries and Tax Implications

Beneficiaries are typically classified as either primary beneficiaries or contingent beneficiaries:

• Primary beneficiaries are the individuals directly named to inherit the assets.
• Contingent beneficiaries inherit only if the primary beneficiary predeceases the account holder or declines the inheritance.

Tax rules differ based on the beneficiary type:

• Spousal Beneficiaries: Have the option to treat the account as their own, with flexible distribution options.
• Non-Spousal Beneficiaries: Generally must follow the 10-year rule for distributions.
• Minor Children, Disabled, and Chronically Ill Beneficiaries: Qualify for special treatment and may avoid the 10-year distribution requirement.

Understanding the SECURE Act and Its Impact on Inherited Accounts

The SECURE Act, enacted in 2019, introduced significant changes for inherited retirement accounts. For most non-spousal beneficiaries, the act requires that inherited retirement accounts be distributed within a 10-year period following the account holder’s death. There are exceptions for eligible designated beneficiaries (EDBs), including spouses, minor children, and disabled individuals, who may continue to follow the traditional RMD rules instead.

Tax Rules for Different Types of Inherited Retirement Accounts

Tax Implications for Inherited Traditional IRAs

Inherited traditional IRAs are subject to income tax on distributions. Beneficiaries of traditional IRAs must adhere to required minimum distributions (RMDs) if they fall into the eligible designated beneficiary category. Non-spousal beneficiaries must follow the 10-year rule, meaning all assets must be withdrawn by the end of the 10th year following the original owner’s death.

Tax Implications for Inherited Roth IRAs

Unlike traditional IRAs, Roth IRAs allow beneficiaries to withdraw funds tax-free, provided the account has been open for at least five years. Non-spousal beneficiaries must still follow the 10-year rule, but distributions from Roth IRAs generally remain tax-free, offering an advantage for long-term tax-free growth. Spousal beneficiaries may roll over an inherited Roth IRA into their own Roth account, which can extend the tax-free growth period.

Tax Considerations for Inherited 401(k) and 403(b) Accounts

For non-spousal beneficiaries, inherited 401(k) and 403(b) accounts must be distributed within 10 years under the SECURE Act. Beneficiaries can choose to roll the account into an inherited IRA to take advantage of flexible withdrawal strategies. Additionally, any distributions taken are typically taxed as ordinary income.

Special Considerations for Inherited Annuities within Retirement Accounts

Inheriting annuities within a retirement account presents unique challenges. Beneficiaries can either withdraw the entire amount within five years or choose a payout option that spreads payments over their lifetime, depending on the annuity contract. Any gains are taxed as ordinary income, and it’s crucial to consult a tax advisor to determine the most tax-efficient approach.

Distribution Options for Beneficiaries

Distribution Rules for Spousal Beneficiaries

Spouses have more options when inheriting retirement accounts, allowing them to:

1. Treat the account as their own and defer RMDs until reaching age 73 (if a traditional IRA).
2. Roll over the account into their existing IRA, delaying taxes on distributions.
3. Set up an inherited IRA in their own name and follow the same distribution schedule as the original owner.

These options provide flexibility in terms of tax deferral and RMD management.

Distribution Rules for Non-Spousal Beneficiaries

Non-spousal beneficiaries must withdraw the entire account balance within 10 years, often requiring careful tax planning to avoid large tax bills. Beneficiaries can take distributions at any time within this period, allowing them to manage taxable income over time.

Special Rules for Eligible Designated Beneficiaries (EDBs)

Eligible designated beneficiaries include spouses, minor children, disabled individuals, and chronically ill individuals. These beneficiaries may follow the original RMD schedule rather than the 10-year rule, allowing for extended tax deferral. Minor children, however, must switch to the 10-year rule upon reaching the age of majority.

Rollover Options for Inherited Accounts

Some beneficiaries may choose a direct rollover of the inherited account into an inherited IRA. This option provides flexibility and control over distributions, especially for beneficiaries aiming to manage taxable income across multiple years.

Tax Strategies for Managing Inherited Retirement Accounts

Minimizing Taxable Income through Strategic Withdrawals

A common strategy to minimize tax liability on inherited accounts is to spread out withdrawals to avoid higher tax brackets. By aligning distributions with lower-income years, beneficiaries can avoid large tax bills and keep more of their inheritance.

Roth Conversions for Beneficiaries of Traditional IRAs

In some cases, beneficiaries may convert an inherited traditional IRA into a Roth IRA. This conversion can lead to long-term tax savings, especially if they anticipate being in a higher tax bracket in the future. Though this involves upfront tax payments, the Roth IRA’s future growth is tax-free, offering significant benefits over time.

Tax-Loss Harvesting to Offset Inherited IRA Distributions

Tax-loss harvesting, a strategy where investment losses offset gains, can help reduce taxable income from IRA distributions. By selling assets at a loss to counterbalance gains, beneficiaries can potentially reduce their overall tax liability.

Donating RMDs to Charity through Qualified Charitable Distributions (QCDs)

Qualified Charitable Distributions (QCDs) allow beneficiaries to donate RMDs directly to a charity. This donation helps fulfill RMD requirements while reducing taxable income. QCDs are particularly useful for beneficiaries who don’t need the income from the RMDs and want to support a charitable cause.

Special Situations and Tax Planning Considerations

Inherited Retirement Accounts for Minor Children and Guardianship Considerations

For minor children, inherited accounts are often managed by guardians or parents until the child reaches the age of majority. The SECURE Act allows minors to use the RMD schedule, but they must shift to the 10-year rule upon reaching adulthood. Parents and guardians should consult with advisors to manage these accounts efficiently.

Handling Inherited Retirement Accounts in Divorce or Legal Disputes

In cases of divorce or legal disputes, inherited retirement accounts may be subject to division or legal requirements. To protect inherited assets, beneficiaries should work with estate attorneys and financial advisors to ensure these assets are handled in compliance with legal agreements.

Estate and Inheritance Tax Implications for Inherited Retirement Accounts

While retirement accounts typically avoid estate taxes if structured correctly, larger accounts can create estate tax liabilities. Certain states also impose inheritance taxes. Beneficiaries can minimize these taxes through strategic planning, including using trusts or spreading withdrawals over multiple years.

Working with Financial and Tax Professionals

Inherited retirement accounts have complex rules, making it essential to consult financial advisors, tax professionals, or estate planners. Professionals can help beneficiaries navigate IRS requirements, develop a tax strategy, and ensure compliance with distribution rules, maximizing the inheritance’s value.

Frequently Asked Questions (FAQs)

What Taxes Apply to Inherited Retirement Accounts?

Inherited retirement accounts are generally subject to income tax on distributions, depending on the account type. Roth IRAs offer tax-free withdrawals, while traditional IRAs and 401(k)s are taxed as ordinary income.

How Does the 10-Year Rule Affect Non-Spousal Beneficiaries?

The 10-year rule mandates that non-spousal beneficiaries fully distribute inherited accounts within 10 years of the account holder’s death, with no required minimum distributions during that period.

Can Spouses Rollover Inherited Retirement Accounts Tax-Free?

Yes, spouses can roll over inherited retirement accounts into their own IRAs, providing tax deferral and the option to delay RMDs until age 73 for traditional accounts.

Are Inherited Roth IRAs Subject to Required Minimum Distributions?

Yes, inherited Roth IRAs require RMDs for non-spousal beneficiaries, though these withdrawals remain tax-free as long as the account has been open for five years.

What Are the Best Tax Strategies for Minimizing Taxes on Inherited Accounts?

The best strategies include spreading withdrawals over multiple years, using Roth conversions, and, if eligible, making qualified charitable distributions.

Conclusion

Understanding the tax implications of inherited retirement accounts is vital for beneficiaries seeking to maximize their inheritance. From the 10-year rule to specialized strategies like Roth conversions, effective tax planning can help beneficiaries manage inherited accounts efficiently. Beneficiaries should consider working with qualified professionals to create a customized plan that aligns with their financial goals and minimizes their tax burden.

Please contact Lynn Conover at lconover@curchin.com with any additional questions or feedback regarding Estate Planning.