How to deal with the complicated rules for an inherited 401 (k) or IRA

So you inherited a retirement account.

Before making any decisions about when and how to access the money, it’s worth familiarizing yourself with the rules that apply to different beneficiaries. The rules for these pension plans can be complicated. Therefore, mistakes can be made, and depending on the details, they are difficult to undo.

Because of the Secure Act 2019, your options for handling an inherited 401 (k) plan or an individual retirement account now largely depend on your relationship with the person who passed away. That legislation eliminated many beneficiaries’ ability to extend benefits over their own lifetime if the original account owner died on January 1, 2020 or later.

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Unless you come across an exception – for example, you are the spouse or minor child of the deceased – those inherited accounts should now generally be exhausted within 10 years.

Here’s What You Need to Know.

If the beneficiary is the minor child of the deceased, the 10-year exhaustion rule will come into effect once they reach the age of majority where they live. In most states that is 18 years.

Before reaching that point, however, the child should take the minimum annual benefits required, or RMDs as they are known, based on their own life expectancy. (Those required withdrawals usually begin for retirement savers at age 72 – or 70½ if reached before 2020 – based on the expected life of the account owner.)

“So if you have a 10-year-old taking RMDs, they would until age 18, when they switched to the 10-year rule,” said Brian Ellenbecker, a certified financial planner with Shakespeare Wealth Management in Pewaukee. , Wisconsin.

In addition, a beneficiary who is chronically ill or disabled, or someone who is no more than 10 years younger than the deceased, can receive benefits based on their own life expectancy and is not subject to the 10-year rule.

If you’re a beneficiary who falls under the 10-year exhaustion rule because you don’t meet an exception, it’s important to consider how you’re going to meet that requirement.

“There is no set amount to withdraw each year, it just has to be withdrawn all within those 10 years,” said CFP Peggy Sherman, a principal adviser at Briaud Financial Advisors in College Station, Texas.

The process basically involves setting up an inherited IRA and transferring the money to it. This is the case regardless of whether the original account is an IRA or 401 (k).

There are a few different things to consider in this situation, including whether the acquired account is a Roth or a traditional version.

Distributions from Roth accounts are generally tax-free, while traditional distributions are taxed on withdrawal. (Note that if you inherit a Roth account that has been open for less than five years, all income withdrawn is subject to tax, while after-tax amounts contributed are still tax-free.)

So if it’s a Roth and you don’t pay taxes on benefits regardless of when you receive them in that 10-year period, it might be worth leaving the money there until year 10 so it can continue to grow tax-free, said Sherman.

On the other hand, if it’s a traditional IRA or 401 (k) it’s worth evaluating the tax aspect of taking distributions. Since the money would be taxed as regular income, taking a lot at once could put you in a much higher tax bracket. Spreading benefits over the decade could minimize the tax burden in any given year.

Failure to clear the account within 10 years may result in a 50% fine on the assets in the account.

Meanwhile, heirs sometimes get a retirement account through an estate – in other words, they weren’t the listed beneficiary, but end up with the account when the estate goes through succession and assets are distributed.

In this case, other rules come into effect. The account should generally be depleted within five years if the original account owner had not started taking RMDs, Vanguard said. If RMDs were in progress, the heir should essentially let those withdrawals go ahead.

Spouses have more options when they inherit a retirement account.

The first is to roll the money into your own IRA. In this case, you would follow the standard RMD rules – that is, when you reach the age of 72, start making the required withdrawals based on your own life expectancy.

“If the surviving spouse does not need the income, this is probably the best option as it may give him time to grow the money in the account,” said Ellenbecker of Shakespeare Wealth Management.

However, he said this also means that you will be fined a 10% early withdrawal if you are under the age of 59½ and withdraw money from that account.

The way to avoid that is to put the money in an inherited IRA and remain the beneficiary. In that case you will not be fined. In addition, RMDs – which are based on your life expectancy – don’t have to start until the deceased spouse reaches the age of 72, Ellenbecker said.