How to handle the complicated rules for an inherited 401 (k) or IRA

So you inherited a retirement account.

Before you make decisions about when and how to access the money, it is worthwhile to familiarize yourself with the rules that apply to different beneficiaries. The rules for these retirement plans can be complicated. Therefore, mistakes can be made, and depending on the details, it can be difficult to undo them.

As a result of the Security Act of 2019, your options for dealing with an inherited 401 (k) plan or individual retirement account now largely depend on your relationship with the person who died. That legislation eliminated the ability of many beneficiaries to extend distributions over their own lifetime if the original account owner died on or after January 1, 2020.

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Unless you meet an exception – for example, you are the spouse or minor child of the deceased – the inherited accounts must usually be depleted within ten years.

Here’s what to know.

If the beneficiary is the minor child of the deceased, the ten-year rule of exhaustion begins as soon as they reach the age of majority where they live. In most countries it is 18 years old.

Before the child reaches this, however, the child must annually take the required minimum distributions, or RMDs as they are known, based on their own life expectancy. (The required withdrawals usually start for pension savers at age 72 – or 70½ if reached before 2020 – based on the life expectancy of the account holder.)

“So if you have a ten-year-old taking RMDs, they will do so until the age of 18 when they go to the ten-year rule,” said Brian Ellenbecker, a certified financial planner at Shakespeare Wealth Management in Pewaukee. , Wisconsin.

In addition, a beneficiary who is chronically ill or disabled, or one who is not more than ten years younger than the deceased, can take benefits based on their own life expectancy and are not subject to the 10-year rule.

If you are a beneficiary who is subject to the 10-year exhaustion rule because you do not meet an exception, it is important to consider how you will meet the requirement.

“There’s no fixed amount you have to take every year, it just has to be withdrawn within ten years,” said CFP Peggy Sherman, a senior adviser at Briaud Financial Advisors in College Station, Texas.

The process basically involves setting up an inherited IRA and transferring the money to it. This is the case if the original account is an IRA or 401 (k).

There are a few different things to consider in this situation, including whether the inherited account is a Roth or traditional version.

Benefits from Roth accounts are generally tax-free, while traditional accounts are taxed on withdrawal. (Note that if you inherit a Roth account that is open for less than five years, any income you withdraw will be subject to tax, while the contribution after tax will still be tax-free.)

So if it’s a Roth and you will not pay tax on benefits, no matter when you take it during the ten years, it may be worth leaving the money there until 10, so that it can continue to grow tax-free, Sherman said.

On the other hand, if it’s a traditional IRA or 401 (k), it’s worth evaluating the tax aspect of benefits. Because the money would be taxed as ordinary income, you could end up in a much higher tax group all at once. The spread of the distributions over the decade can reduce the tax hit in any given year.

If you do not empty the account within ten years, 50% penalties can be imposed on any assets left in the account.

Meanwhile, heirs sometimes have a retirement account via an estate – in other words, they were not the listed beneficiary, but ended up having the account as the estate goes through the estate and assets are distributed.

In this case, different rules come into play. The account must generally be depleted within five years if the original account owner, according to RMR, has not started taking RMDs. If RMDs were in place, the heir would essentially have to keep the withdrawals going.

Spouses have more options if they inherit a retirement account.

The first is to roll the money into your own IRA. In this case, you will follow the standard RMD rules – that is, when you turn 72, you will start the required withdrawals based on your own life expectancy.

“If the survivor does not need the income, it is probably the best option because it could possibly give them time for the money to continue to grow in the account,” said Ellenbecker of Shakespeare Wealth Management.

That said, it also means you will be subject to an early withdrawal penalty of 10% if you are under 59½ and withdraw money from the account.

The way to avoid this is to put the money in an inherited IRA and stay the beneficiary. In this case, you would not be punished. In addition, RMDs – which are based on your life expectancy – do not have to start until the deceased spouse is 72 years old, Ellenbecker said.