You Inherited a Retirement Account: Now What?

For years now, basic financial planning knowledge has inspired most hard-working Americans to boost their contributions to qualified retirement accounts.

Doing this can be a powerful way to lower your current income tax liability, have your savings grow exponentially tax-free, and, in most states, can protect your savings from claims of creditors. This is what a large majority of American workers have done. 

Obtain Professional Advice Before Filing a Claim 

If a loved one passes owning a qualified retirement plan such as an IRA or 401k, and if you believe that you are a beneficiary of that plan, the first thing you need to do is to contact the financial institution or keeper of the plan as soon as possible. Usually, a copy of the retirement plan statement will have contact information for the financial institution where the retirement plan is being held.

You need to speak with the beneficiary claims department and let them know that you think you may be a beneficiary on your loved one’s retirement account. Financial institutions will typically not confirm or deny beneficiary status over the phone. However, they will confirm information such as your full name, date of birth, address, and possibly your Social Security number. They will also usually request that you provide them with a copy of the plan owner’s death certificate. If you are confirmed to be a beneficiary, they will send you a copy of a beneficiary claim form at the address that is listed in their system. 

Once you are in possession of the claim form, you should read it over cautiously and get advice of a reliable tax professional such as your CPA, your estate planning attorney, or your financial advisor. These professionals can help you understand the multiple options that such beneficiary claim forms provide. 

For example, most claim forms allow at least three options for making a beneficiary claim: 

• A lump-sum payout of the plan proceeds to which you are entitled 
• Establishing an inherited IRA account with the same financial institution 
• Making a trustee-to-trustee transfer of the plan benefits to another institution that will receive the benefits as an inherited IRA or a spousal rollover 

Depending on the financial institution, you may be offered additional options. If you choose to take a lump-sum payout of the plan proceeds, it is important to remember that qualified retirement plans (with the exception of Roth IRAs) have not yet been subject to income tax.

So, if you withdraw the plan proceeds in the form of cash or check and you deposit that check, you will be responsible for paying income tax on every dollar that is deposited into your bank account. The financial institution will notify the IRS that the payout was made to you, and you will receive a 1099 form from the financial institution at the end of the year for your own income tax reporting purposes. Depending on your annual income, this additional income might easily push you into a higher tax bracket and create significant income tax liability for that year. 

As a result of this potential tax liability, most of the beneficiary claim forms will ask you whether you want to withhold a percentage of the payout for payment of income tax. The financial institution may automatically determine the amount that is withheld, or it may allow you to specify how much to withhold.

If you have the option of determining how much to withhold, you should seek the advice of an income tax professional to help you determine what would be the appropriate amount. 

Before Taking a Lump-Sum Payout, Consider This 

Choosing a lump-sum payout may be enticing even with the potential high tax liability. But before you make that decision, you should consider some of the benefits that are provided by the other options. 

Spouse of IRA Owner 

First, if you are the surviving spouse of a deceased qualified plan owner, you can move the inherited account into your own IRA (called rolling over) and treat the account as your own IRA. Which allows you to use your age to determine when you must begin to take required minimum distributions and how much you must withdraw annually.

This choice can be especially favorable if you are younger than your deceased spouse and have no current need to start withdrawing amounts from the IRA. By postponing the withdrawals until you reach 72 years old, the account will have more time to grow in a tax-deferred environment. Also, certain creditor protections will be available for your own IRA that are not available for an inherited IRA. 

Another choice is that you can choose to accept the inherited account as an inherited IRA. This choice can be useful for surviving spouses younger than 59 ½ who need access to the money in the plan urgently to provide for their support.

With an inherited IRA, a surviving spouse who is younger than 59 ½ would not be subject to the 10 percent early withdrawal penalty that would be assessed if the surviving spouse were to roll over the deceased spouse’s IRA into the surviving spouse’s own plan.

Although, in most states, an inherited IRA will not afford you any creditor protection, unlike rolling over the IRA into your own IRA. For those with creditor protection concerns, this might be an important factor to consider: 

Non-Spouse Beneficiaries 

If you are the beneficiary of a plan owner, but not the spouse or a beneficiary who otherwise fits within the definition of an Eligible Designated Beneficiary (i.e., a surviving spouse, a minor child of the deceased owner, a disabled or chronically ill individual, or any other person who is not more than ten years younger than the deceased account holder), then you usually will have to withdraw all plan assets to which you are entitled to by December 31st of the 10th anniversary year of the plan owner’s death. If you do not, you will be subject to a 50% penalty for the amount that you should have withdrawn by that time. 

If you are an Eligible Designated Beneficiary, you will qualify for a largely lowered rate of required minimum distributions. This rate is usually figured out over your life expectancy. A minor child is not required to take out any distributions until the child reaches the age of majority. At that point, the ten-year rule applies the same as it would for a non-Eligible Designated Beneficiary. 

Regardless of how quickly you are required to take out the plan benefits, remember that the distributions will be reported as income on your tax return for that year. Make sure to set aside (or have the financial institution withhold) enough so that you are able to pay the tax on that income when you have to. 

Do Not Forget to Name Your Own Beneficiaries

Not naming your own beneficiaries is a frequent mistake when someone inherits a retirement plan. When a plan owner dies without having named a beneficiary (whether for the plan owner’s own plan or an inherited plan), it can cause significant hassle and increased tax liability.

The IRS provides more favorable tax treatment for individuals who withdraw retirement plan proceeds than for a trust or estate making similar withdrawals. When there are no beneficiaries named on a retirement plan, the default provisions of the plan often make the plan proceeds payable to the estate of the deceased plan owner. Even though the money will eventually pass to the heirs of the estate, this can be an expensive mistake. 

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