Retirement accounts were created to provide investment vehicles for individuals so that after they have stopped working, they could access their funds to cover expenses. Accounts can be employer-sponsored, as in the case of a 401(k) plan, or they can be Individual Retirement Accounts (IRAs).
These accounts are regulated by a host of Internal Revenue Service (IRS) rules, which provide guidelines for maximum yearly contributions, penalties for early withdrawals, and mandatory distribution amounts based upon the age and life expectancy of the account holder.
When the owner of a retirement account dies, the account can be bequeathed to a beneficiary. A beneficiary can be any person or entity that the owner has chosen to receive the funds. If no beneficiary is designated beforehand, the estate will generally become the recipient of the account.
The flexibility that a beneficiary has in terms of what can be done with an inherited retirement account, as well as the tax consequences that accompany the bequest, depends on many different factors. The IRS’ broad array of rules and options are based on the type of IRA (traditional or Roth), whether or not a beneficiary was designated, whether the account holder died before or after the beginning date of “required minimum distributions” (RMDs), and whether the account’s sole beneficiary is a surviving spouse.
Understanding the complexity of choices that face a retirement account beneficiary is key to satisfying IRS mandates, as well as maximizing the financial advantages of any inherited monies. Owners and future beneficiaries of retirement accounts are advised to seek professional advice before taking any action regarding them.
Options for a Surviving Spouse
A surviving spouse who is the sole beneficiary of a retirement account has several choices. According to IRS rules, he or she can:
Treat the IRA as his or her own.
A surviving spouse can designate himself or herself as the account owner. All of the standard rules applying to the account would then apply to the surviving spouse. The spouse could then make contributions and withdrawals, and name new beneficiaries. Withdrawals are subject to a 10 percent federal income tax penalty if the spouse has not reached age 59 ½. Required minimum distributions begin at age 70 ½.
When any funds are withdrawn or distributed from the account, all nondeductible amounts would be taxable as gross income. In addition, if required minimum distributions are not taken according to IRS rules, a 50 percent excise tax is levied on the amount that was not withdrawn, but should have been. (This penalty applies to all beneficiaries.)
Roll the account over into his or her own retirement account.
Some retirement plans require that a deceased employee’s account be distributed in a lump sum. In order to avert an immediate tax obligation, a surviving spouse could roll over the account into his or her own IRA or other retirement plan. (Surviving spouses have 60 days after the death to roll over the money.) Required minimum distributions would begin when the surviving spouse turns 70 ½.
Continue as the beneficiary.
This option works best if an individual dies before the age of 70 ½ and the surviving spouse has not reached 59 ½. Required distributions would be delayed until the point at which the deceased individual would have had to make them. The surviving spouse would be able to withdraw funds without incurring the 10 percent early withdrawal penalty. Once the surviving spouse reaches age 59 ½, the account could be rolled over.
A surviving spouse can also choose the 5-Year Rule option if the spouse died before age 70 ½. This election requires the surviving spouse to withdraw all of the funds by December 31 of the fifth year following the death.
If a surviving spouse is not the sole beneficiary, other rules would apply. In addition, the guidelines are different if the inherited account is a Roth IRA or another plan on which taxes have been pre-paid. Again, it’s best that the plan’s sponsor, a financial expert and a tax expert be consulted before any decisions are made.
Non-spouse beneficiaries have different options and restrictions.
They can choose:
- To cash out the account and pay taxes on the distribution.
- The 5-Year Rule payout option, if the account holder died before age 70 ½.
- To treat the account as an inherited IRA, which would require minimum distributions to be taken by December 31 of the year following the account owner’s death.
Non-spouse beneficiaries cannot roll over an inherited IRA into their own account, nor can they treat the IRA as their own. In addition, non-spouse beneficiaries could be liable for paying estate taxes if the value of the retirement account plus other inherited assets exceeds estate tax exemptions.
If the beneficiary is a revocable trust, distribution rules can be extremely complex, requiring expert legal assistance.
No Designated Beneficiaries
If an account holder did not designate a beneficiary, typically the account would become part of the estate to be dispersed through probate court. If the account holder died before age 70 ½, the resulting beneficiary would be required to use the 5-Year Rule.
If the account holder died after required minimum distributions had begun, the distribution period for the beneficiary would be based on the deceased’s age and distribution schedule.
The complexity of the rules for inherited retirement accounts cannot be overstated. In order to prevent a legal or financial predicament, it is imperative that an account beneficiary get reliable information from a qualified professional who is familiar with IRS regulations.