Want to pay less taxes on inherited retirement accounts? Beneficiaries of retirement accounts have options available to them that in the long run may result in increased benefits and less taxes due. But if no decisions are made, the tax code dictates how the distributions are to be taken, even if it results in increased income taxes and penalties of ten or even fifty percent. All it takes is a little bit of pre-planning and you can keep the taxes you owe to a minimum.
Three Options for Beneficiaries
Unlike assets that are inherited through an estate, a retirement account passed to a beneficiary becomes taxable to the beneficiary in the same way that it would have been taxable to the person who passed away. The good news is, as a beneficiary you usually have some choices regarding how you receive this income. In general, there are three options:
Disclaiming the Account
First, you can decide you do not want the money, which is known as “disclaiming” the account. You may wish to do this if you want the account to go to the alternate beneficiaries, or if you want to avoid the tax implications of additional income. The disclaimer usually must be within nine months following the date of the passing of the decedent and before you have taken possession of the funds.
Lump Sum Distribution
Second, you can take all of the money at the time you inherit it as a “lump sum distribution.” The tax consequences will vary depending on the type of account you inherited (deferred taxation vs. Roth type accounts) and the extent to which a tax-deferred account was made up of pre-tax or post-tax contributions.. As mentioned above, if the income would have been taxable to the dearly departed, it is taxable to you in the same way. The word of caution here is that if you have to pay income tax on the funds you take out of the account, you should be careful that the amount is not so large that it pushes you into a higher tax bracket, causing you to perhaps pay more in income tax than if you had delayed the distributions.
Rollover to an IRA
The third option is to roll the money over to a beneficiary IRA account. There are different rules for spouses and non-spouses. If you are the spouse of the deceased and the sole beneficiary, you can elect to treat the inherited account as your own or elect to be treated as a beneficiary. The election to treat it as your own can be made at any time after the date of death of the deceased person, but once made it is an irrevocable election. You can then put the money into your own IRA, set-up separate IRAs, make contributions, additional rollover contributions, or however you choose to handle it. The inherited amounts will still be taxable to you if they would have been taxable to the decedent, but the distribution rules will depend on your age and life expectancy. Any distributions you make from your own IRA before you reach age 59½ will be subject to a 10% additional penalty tax.
Non-spouse beneficiaries (and spouses who choose to be treated as non-spouses) may do a direct rollover (trustee-to-trustee) to a non-spouse beneficiary IRA by December 31st of the year following the year of death of the original account owner. The non-spouse beneficiary under age 70½ can elect to take the distributions based on his or her life expectancy (called a “stretch” IRA), or if this election is not made the entire amount has to be distributed by the end of the fifth year following the year of the date of death.
If you don’t need or want the use of money right away, the third option is likely your best choice. Distributions from beneficiary IRAs must be done according to Required Minimum Distribution (RMD) rules, which will be covered in a later post.