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Inherited Retirement Accounts Part I: Spouse Beneficiary

by Jennifer Santini on April 13, 2012

Savings - iStockThere is often confusion about what to do when a beneficiary inherits a retirement account. The answer is… it depends. There are different factors to determine the best course of action, such as the beneficiary and the age of the decedent.

For purposes of this article, the term “retirement account” will be used to encompass all qualified retirement accounts, meaning a tax deferred retirement account such as a traditional IRA or a 401(k). As a reminder for some, and background information for others, anyone who owns a qualified retirement account must begin taking required minimum distributions (“RMDs”) during the year in which they turn 70 ½ years old. The RMD is calculated according to the IRS chart, which can be found here.

One of the purposes of the RMD is to have taxes paid on the retirement account since the assets in these accounts, which were invested with pre-tax dollars, have been growing tax-deferred over the lifetime of the account. For some individuals they may never need the assets in these accounts and, therefore, could just keep the assets in the accounts to continue to grow without incurring tax. However, the federal government requires individuals, at the very least, to systematically withdraw minimal funds to incur tax. (An important note – failure to take the RMD in any required year incurs a tax penalty of 50% of the RMD amount.)

When an account holder passes away, hopefully they will have properly listed beneficiaries on the account to inherit these assets. The assets can be transferred/inherited in various ways, again depending on the beneficiary and the age of the decedent. The two main questions to ask to determine the options available to the beneficiary are:

  1. Is the beneficiary the spouse of the decedent?
  2. Had the decedent reached 70 ½ years of age during the calendar year?

This post will address the basic options available to a spouse beneficiary. Later this month I’ll address the options available to a non-spouse beneficiary. As we always note, it is important to consult with a proper professional advisor such as a financial advisor, accountant or attorney before making these decisions to ensure you are choosing the appropriate option for your particular situation. Additionally, it is also important to note that a beneficiary, regardless of the answers to the two questions above, always has the option to take the retirement account in one lump sum distribution. However, the beneficiary will have to recognize the distribution as income and pay taxes on it.

Decedent Had NOT Reached The Age of RMD

Rollover: If the decedent had not reached the age of the RMDs and the beneficiary is a surviving spouse, then the surviving spouse can actually roll the decedent spouse’s retirement account into his or her own IRA and can assume the account as if the decedent spouse never owned the account in the first place. The RMDs would then be based off of the surviving spouse’s life expectancy and would not have to begin until the year in which that spouse attains age 70 ½.

Inherited IRA: Another option is that the surviving spouse could maintain the retirement account as an inherited IRA. Again, the RMDs are based off of the surviving spouse’s life expectancy however, that spouse will have to take RMDs from the account by the later of a) December 31st of the year after the decedent’s death or b) December 31st of the year the owner would have reached age 70 ½.

5-year Rule: Lastly, if the surviving spouse has not chosen either of the two options above, the surviving spouse must withdraw all of the assets from the retirement account by December 31st of the fifth year following the decedent’s death. The surviving spouse can withdraw as much or as little in any of those given years, but at the end of the 5-years, all of the assets must be withdrawn.

Decedent HAD Reached The Age of RMD

If the decedent had reached 70 ½ years by the time of death, it is important to note that a RMD must still be taken for that year. For example, if the decedent reached 70 ½ in February but died in June of the same year, the estate or beneficiary must take the RMD by December 31st of that year.

Rollover: If the decedent had reached the age of RMDs and the beneficiary is a surviving spouse, then again the surviving spouse can roll the decedent’s retirement account into his or her own IRA. The RMDs can then be based off of the surviving spouse’s life expectancy and would not have to begin until the year in which that spouse attains age 70 ½.

Inherited IRA: The surviving spouse also has the option to roll the decedent spouse’s retirement account into an inherited IRA and can opt to base the RMDs off of the surviving spouse’s life expectancy or the decedent’s remaining life expectancy. The latter option is typically chosen if the decedent spouse was younger than the surviving spouse.

There is no 5-year rule option if the decedent had reached 70 ½ years because RMDs would be required to be taken each year and cannot be forgone.

To complicate matters, surviving spouses also have the option to disclaim assets for tax purposes and can direct assets into trusts. We have outlined how to disclaim assets under Federal law and under Minnesota law, which can be found here and here. Retirement accounts directed to trusts carry a whole host of different options that will not be covered in this post. But as an important reminder, you cannot accept any interest in property that will be disclaimed, so be aware of timing if RMDs need to be taken by the end of a given year.

Lastly, it is important that your beneficiary designations on retirement accounts are up-to-date to ensure they will go to the correct person. If you wish to direct a qualified retirement account to someone other than your spouse, your spouse will have to consent to this. To read some helpful information on conducting a thorough beneficiary review, click here.

Again, please consult with a financial advisor, accountant or attorney to determine the best available options for maximizing the benefits of the retirement account and minimizing the tax consequences.

 

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Article by Jennifer Santini

Jennifer has written 135 awesome articles for us.

Jen is a founding partner at the law firm Sykora & Santini, which focuses on business law and estate planning. Prior to forming Sykora & Santini, Jen spent the majority of her professional career in the financial services industry in Boston, working in the legal departments of two investment management companies while attending law school.

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