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What You Need to Know about an Inherited IRA or 401(k)

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Adobestock ScaledAn inheritance can come in many forms. One of the assets that is frequently passed down to loved ones is an IRA or 401(k) account. If you recently inherited one of these accounts, you need to understand the rules and the tax consequences that go along with your inheritance. Toward that end, the Essex Junction estate planning attorneys at Unsworth LaPlante, PLLC explain what you need to know about an inherited IRA or 401(k).

Estate Tax Basics

When an individual passes away, his/her estate typically must go through the legal process known as probate. During probate, the estate assets are identified and valued. If the probate assets exceed the current lifetime exemption amount, the excess assets are subject to federal (and sometimes state) gift and estate taxes at the rate of 40 percent. The remaining estate assets are then transferred to the beneficiaries and/or heirs of the estate. Because the assets have already been taxed, the recipients do not need to worry about paying taxes most of the time. When the asset in question is an IRA or 401(k) though, the rules are a bit different.

Traditional IRA and 401(k) Rules

A traditional IRA or 401(k) is a retirement plan that allows an individual to save money for retirement over the course of their working years. The funds in the account grow tax-free until the individual reaches his/her retirement years. At the age of 70 ½, however, the rules say that the account owner is required to start taking money out of the account. These withdrawals are referred to as called the “required minimum distributions” (RMD).” Those RMDs are taxed. The benefit of a traditional IRA or 401(k) is that you will presumably be in a lower tax bracket as a retiree, meaning you are paying less taxes on the money you saved than you would have paid had you reported it as income during the year you earned it.

If the owner of a traditional IRA/401(k) dies, the named beneficiary inherits the account unless one was not named. In that case, the assets will likely become part of the decedent’s estate. The rules for the beneficiary of an inherited IRA/401(k) depend on whether the beneficiary is a spouse or not, as follows:

  • Spousal beneficiary rules. If the account owner had not yet started taking distributions, an inheriting spouse has the option to roll the inherited IRA into his/her own IRA. The beneficiary will not be required to take distributions until age 70 ½. The inheriting spouse can also leave the account as if there is an immediate need to withdraw the funds; however, most spouses roll the IRA over so it can continue to earn money tax-free.
  • Non-spouse beneficiary rules. When anyone other than a spouse inherits a traditional IRA/401(k), additional money cannot be added to the account. Moreover, the beneficiary is required to start making RMDs the following year and the money withdrawn is subject to personal income taxes. If you don’t take out the RMDs, the IRS will impose a penalty. The beneficiary also has the option to take all the money out of the account; however, keep in mind that it is all taxable. If the account owner had not yet started taking distributions, the beneficiary can also decide to keep the funds in the account for up to five years. Taking out small distributions each year is typically the best financial choice, though you can always decide to take out a larger amount one year is necessary.

Roth IRA’s and Roth 401(k)s

If the inherited account is a Roth IRS or a Roth 401(k) the rules are different because taxes were paid on the income as it was transferred into the account. As a rule, if you are a spouse, you can delay distributions until the time when the deceased IRA owner would have been 70 ½ or treat the Roth IRA/Roth 401(k) as your own. If you are a non-spouse beneficiary, you will have to withdraw the assets in that inherited Roth IRA within five years. Either way, you will not owe taxes on the inherited assets if the Roth has been open for at least five years.

Contact Essex Junction Estate Planning Attorneys

For more information, please attend one of our upcoming FREE webinars. If you have additional questions or concerns related to an inherited IRA or 401(k), contact the experienced Essex Junction estate planning attorneys at Unsworth LaPlante, PLLC by calling 802-879-7133 to schedule your appointment today.

Stephen Unsworth
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