When the account owner of a traditional individual retirement account (IRA) or employer sponsored retirement account dies, the remaining funds in the account pass to the named beneficiary.
Unlike other inherited assets, IRA’s and employer sponsored retirement accounts typically pass directly to the beneficiary without having to go through probate.
Although the beneficiary will receive the funds from the IRA or employer sponsored retirement account, they may be responsible for federal and state income taxes on the amount they inherent which will reduce the net amount of their inheritance.
For individuals who inherent a retirement account, the options will vary on how you can take the distribution depending on if you are a spouse or another individual (ex: child, brother or sister).
A surviving spouse beneficiary can elect to roll over the inherited funds to his or her own IRA account, leave the funds in the deceased persons account and have it reregistered in their name, or take the money out.
If the surviving spouse rolls over the money or has the account reregistered to their name, then they will not have to pay federal and state income taxes until the money is withdrawn at a future date.
If the surviving spouse decides to withdraw the money immediately, then they will be responsible for the income taxes that are due on the withdrawal. The surviving spouse will also have the following options of other beneficiaries if they choose.
For those individuals that inherent an IRA or retirement account and are not the surviving spouse, they will have the following options on how to receive the funds.
- LIFE EXPECTANCY METHOD: This method involves taking distributions over a beneficiary’s single life expectancy.
The distribution must begin no later than December 31 of the year following the IRA owner’s death.
This will result in a monthly income for the life of the beneficiary and they will only be responsible for the federal and state income taxes on the amount they receive each year.
- FIVE-YEAR RULE: Under this method, the IRA or plan beneficiary must distribute the entire balance of the inherited funds within a five-year period.
The five-year period ends on December 31 of the year during which the fifth anniversary of the IRA owner’s or plan participant’s death occurs. For example: if you inherited $100,000 in an IRA account from your brother and you choose the five-year rule, then you would receive $20,000 a year for five years.
You will be responsible for federal and state income taxes on $20,000 each year.
- LUMP-SUM DISTRIBUTION: A lump-sum distribution is the withdrawal of the entire balance of an inherited IRA or employer-sponsored retirement plan account in one tax year.
As an IRA or retirement plan beneficiary, you will generally be subject to federal and state income tax on a lump-sum distribution for the tax year in which it is taken.
For this and other reasons, a lump-sum distribution is generally not regarded as the best way to distribute funds from an inherited IRA or plan.
Other options for taking post-death distributions will typically provide more favorable tax treatment and other advantages.
For example: if you inherited $100,000 in an employer retirement account and you choose a lump sum distribution, then you would receive $100,000 during that year.
You will be responsible for the federal and state income taxes on the $100,000 for that tax year.
- DISCLAIM THE INHERITED FUNDS: When you disclaim all or part of a traditional IRA or retirement plan account, you voluntarily refuse to accept some or all of the inherited funds.
As you might guess, disclaiming is not common. Disclaiming a benefit may actually make sense in certain circumstances.
For example, you may decide to disclaim so that the funds pass directly to a contingent beneficiary with greater financial need or because you already have estate tax problems and you do not want to further compound the problem by increasing your estate even more.
Steven J. Bailey CFP®, CLU, ChFC is a registered representative of American Portfolios Financial Services, Inc. Member FINRA/SIPC, Advisory Services offered through American Portfolios Advisors, Inc., located at 992 E. State St. Salem and can be reached at 330-337-7720 or www.baileyfinancialplanning.com if you should have any further questions regarding this matter.