Inheriting a Retirement Account? Follow the Rules or You'll Regret It

×
IRAWith Social Security in crisis and workers struggling to build up any sort of nest egg for their retirement years, you might figure that the odds of anyone having money left in their retirement accounts to leave to their loved ones would be just about zero.

But because many retirees leave their IRAs and 401(k)s untouched as long as possible to avoid paying unnecessary taxes, you might someday face the bittersweet experience of inheriting a retirement account.

If that happens to you, you'll need to know how to avoid big pitfalls that could end up with the IRS taking a huge chunk of that cash. Here are some quick tips that can help you make it through all the rules and regulations governing retirement accounts.

Being Married Matters

The first thing you need to do is to look at the named beneficiaries for the retirement account in question. Whether you're a sibling, child, grandchild, or family friend to the person who passed away, you'll be treated similarly to any other beneficiary.

But a surviving spouse has some additional options that no other beneficiary has. Through what's known as a spousal rollover, a surviving spouse can move the retirement account money into an IRA in the spouse's own name. From then on, the inherited IRA assets are treated in exactly the same way as the surviving spouse's other retirement assets, regardless of the fact that they originally came from the deceased spouse's earnings. In determining things like early-withdrawal penalties and required minimum distributions, the surviving spouse's age will be what matters going forward.

Options for Everyone Else

Everyone except the surviving spouse has fewer options available to them, but they do have a few choices to make. The default rule is that beneficiaries must take out the entire balance of an inherited IRA by the end of the fifth year following the death of the original IRA account holder.

The problem with the five-year rule is that it can leave you with substantial tax liability. Remember, with a traditional IRA or 401(k), any money that you withdraw will be added to your taxable income for the year you receive it. But another option available to most beneficiaries lets you stretch out distributions over a longer period.

To use what's known as a Stretch IRA, you need to withdraw a certain amount of money from the inherited IRA every year, beginning with the year following the death of the original account holder. The amount is recalculated each year, based on IRS tables that help you figure your life expectancy and the value of the retirement account at the beginning of the year. By using this method, you'll have the flexibility to take distributions from the inherited retirement account over anywhere from 20 years for someone who's 65 years old to 40 years or more for someone in their early 40s or younger.

Keep in mind that even if you use the Stretch IRA method, you can always take more money out of your inherited IRA than the calculated amount. The calculations only specify the minimum withdrawal each year.

Get the Details Right

Perhaps the trickiest part of inheriting a retirement account is getting your financial institution to get the necessary paperwork done. For a spousal rollover, nothing could be simpler, as you'll simply end up with a new IRA in your own name without necessarily any reflection that it came from the deceased spouse.

For everyone else, though, you must be sure that you keep your inherited IRA money separate from your own personal retirement accounts. In fact, the account name for the inherited IRA should include the name of the original account holder and reflect the inherited nature of the account. For instance, your account might be titled something like "IRA for benefit of John Doe as beneficiary of Jane Doe." Because brokers don't handle these transactions all that frequently, make sure to follow up to ensure that they've set things up correctly.

It's never easy handling money matters after the death of a loved one. But by making sure you follow the IRS rules governing inherited retirement accounts, you'll avoid seeing hard-earned money go to the tax man rather than family. That's a legacy anyone would be proud of.


Motley Fool contributor Dan Caplinger always has fond memories of his mom when he writes about inherited IRAs. You can follow him on Twitter @DanCaplinger.

Increase your money and finance knowledge from home

Getting out of debt

Everyone hates debt. Get out of it.

View Course »

How Financial Planners go Grocery Shopping

Learn to shop smart and save.

View Course »

Add a Comment

*0 / 3000 Character Maximum

18 Comments

Filter by:
mac2jr

Can an IRA be transferred as a 'Gift' ?

Inheritance Taxes are I believe 4.5% in PA to the family members and 15% to the non-family members. Thus, if the paperwork is correct, can the inheritance be provided to the family member, and he or she 'gift' the item to the non-family member as long as no 'compensation' is exchanged..?

October 24 2012 at 6:50 PM Report abuse +1 rate up rate down Reply
1 reply to mac2jr's comment
MONTOOTH

Non-Roth IRA's, 401K's, 403b's, etc., are funded with untaxed monies. When those funds are distributed, taxes are due. Gifting does not change that. Placing the IRA in a trust or simply naming individuals as beneficiaries, does not change that. The only way to pre-empt taxes paid by heirs for average folks would be to fund Roth IRA's. Of course, taxes are paid upfront, but the same tax benefit extends to heirs of Roth accounts. Personally, if you don't have a Roth(s), work with an attorney to set-up a revocable, living trust.

October 25 2012 at 12:35 AM Report abuse rate up rate down Reply
Winnie

I don't understand why a person works all their lives, saves their money, and then when they die, the money goes to the family and is taxed = again.

October 24 2012 at 6:31 PM Report abuse rate up rate down Reply
1 reply to Winnie's comment
mac2jr

Money put into these accounts is NOT taxed as income when it is placed into the account, only when withdrawn at an old age when the person usually has a much lower income, i.e., Social Security, and therefore is taxed at a much lower rate as it is used..

October 24 2012 at 6:52 PM Report abuse +2 rate up rate down Reply
scottee

rules?
congress keeps changing the rules.
who can keep up?

October 24 2012 at 4:04 PM Report abuse -1 rate up rate down Reply
leandercannon

" dumb: you'll avoid seeing hard-earned money go to the tax man rather than family. That's a legacy anyone would be proud of." avoid taxs to leave money to be fees by the army of wall street leachs...lc

October 24 2012 at 12:51 PM Report abuse rate up rate down Reply
1 reply to leandercannon's comment
onebluebrick

What?

October 24 2012 at 2:18 PM Report abuse +1 rate up rate down Reply
rxrxrx1818

I'm the general blue collar worker that doesn't have a penny in retirement. It's paycheck to paycheck & pawning things in between so I don't have to worry about losing any $ someday. It is what it is. Sometimes, I don't work because I don't have a vehicle & there's no bus route where I live.

October 24 2012 at 2:08 AM Report abuse +1 rate up rate down Reply
1 reply to rxrxrx1818's comment
onebluebrick

Why don't you get an old junker and use it to get to your job until you can afford a little better car? That is what a lot of people do. I drove a '39 Chrysler with no paint to work, until I earned a down payment for a better car. It was not much better, but I kept upgrading unitl I now have a 9 year old Lexus with 80,000 miles on it. It is a good car.

October 24 2012 at 2:24 PM Report abuse rate up rate down Reply
1 reply to onebluebrick's comment
M

And you seem to forget a few things:

1) driver's license
2) auto registration/license/tags, annual
3) annual safety inspection
4) minimum required liability auto insurance
5) upkeep/maintenance, as needed (other than gas, oil, other fluids)
6) gasoline / oil changes

If you are lucky, getting 'into' a junker won;t cost more than those six items; minimum insurance seems to run about $40 / month *if you believe the TV ads*

October 25 2012 at 11:13 AM Report abuse rate up rate down
Jay

People better start thinking of how to move their money offshore. With the national debt closing in on the 22 trillion dollar mark America will go under at that point. The only way Obama can save us is to "federalize" everyones retirement accounts and redistribute the funds they will have taken from you. Then you will be at the mercy of your government and they will give you only what they think you need. Mark my words......it is going to happen.

October 23 2012 at 10:01 PM Report abuse +1 rate up rate down Reply
2 replies to Jay's comment
onebluebrick

YOu should change your name to Joy.

October 24 2012 at 2:25 PM Report abuse rate up rate down Reply
scottee

that's what people want, right? redistribution.
that why they elected him, right? redistribution of your money.
and you are no patriot if you move your money offshore, right?
vote Romney/Ryan.

October 24 2012 at 4:06 PM Report abuse rate up rate down Reply
scottee

when are we going to force congress and all government employees to buy their own IRAs and pay into the social security system instead of what they have now?

October 23 2012 at 4:22 PM Report abuse +2 rate up rate down Reply
1 reply to scottee's comment
pdbocc

Congress, and all federal employees have been paying into the Social Security system since 1984!! That's when Congress eliminated the Civil Service Retirement System and replaced it with the Federal Employees Retirement System. All federal employees contribute to the government's version of a 401K account. It's known as the Thrift Savings Plan, (TSP). The government matches up to 5% of contributions depending on how much the employee contributes. There is also a small, very small, annuity, that both sides contribute to, and finally Social Security. So the federal employee, not the taxpayer, is largely responsible, just like those who work in the general economy, funding their own retirement.

October 23 2012 at 6:23 PM Report abuse +1 rate up rate down Reply
tepextex99

The 5 years stated to take out the entire balance in an inherited IRA is not true. There is a RMD (required minimum distribution) that must be taken each year. The RMD is based on the person's ,who inherits the IRA age.

October 23 2012 at 11:03 AM Report abuse +2 rate up rate down Reply
grnpb

suppose the money to be inherited is in the trust account of the deceased and the inheritor is a named beneficiary in the trust?

October 23 2012 at 10:55 AM Report abuse rate up rate down Reply
1 reply to grnpb's comment
MONTOOTH

My retirement accounts are in a revocable trust and the trust dictates how the distributions are to occur and to whom. I would recommend that folks investigate this alternative as a way to minimize tax risk for beneficiaries. It also can help beneficiaries manage the money if they have little or no experience doing so. My executor for this activity is my investment company. They have the fiduciary to grow the account and distribute it to beneficiaries on a quarterly basis.

October 23 2012 at 3:06 PM Report abuse rate up rate down Reply