In the event of the death of an owner of a traditional individual retirement account (IRA) or employer-sponsored retirement plan, the remaining funds in the account pass to the beneficiary (or beneficiaries) named. Unlike many other assets that one might inherit, these IRA funds or plan funds usually can pass directly to the beneficiary, without having to go through probate.
Also unlike some other inherited assets, the funds in the inherited account are typically subject to federal income tax. For the purpose of calculating federal income tax due, post-death distributions from the inherited account are treated the same as distributions that the account owner took during her or his lifetime. State income tax may also apply. The portion of a distribution representing pretax or tax-deductible contributions and investment earnings is taxed, while the portion that represents after-tax or nondeductible contributions is not taxed. The beneficiary inheriting the account is the one responsible for paying the taxes after the account owner has died.
While IRA or Plan beneficiaries may desire to leave inherited funds in the account as long as possible to postpone taxable distributions indefinitely and maximize the tax-deferred growth potential, that isn’t an option. You will generally be required to take distributions of the inherited funds at some point, and often earlier than you would like.
With that in mind, it’s wise to explore the various options that may be available for taking distributions so you can choose the one that’s best suited to your individual circumstances.
Note: While the same general rules do apply to inherited Roth IRAs, those IRAs are different in that qualified distributions are free from federal income tax.
Post-death distribution options for designated beneficiaries
The post-death distribution options available to designated beneficiaries generally include one or more of the following.
The life expectancy method
Typically the default payout method, this involves taking the required distributions over a beneficiary’s single life expectancy or, occasionally, over the remaining single life expectancy of the deceased account owner. This option is available regardless of whether the IRA owner or plan participant died before or after the required beginning date for minimum distributions (unless plan provisions specify otherwise). Distributions must begin by December 31 of the year following the year of the IRA owner’s/plan participant’s death.
As one can surmise from the title of this method, it involves the designated beneficiary taking distributions within a five-year period, and they can be taken in any amount and at any time during that window. The five-year period ends December 31 of the year in which the fifth anniversary of the IRA owner’s or plan participant’s death occurs. If no beneficiary has been designated and the account holder died before the required beginning distributions date, the five-year rule is the default rule under the final IRS regulations. In other cases, the life expectancy method is the default rule. While a designated beneficiary can often still elect the five-year rule as an alternative payout method, it is typically not as desirable as the life expectancy method from a tax standpoint.
This option involves withdrawing a beneficiary’s entire interest in an inherited IRA or retirement plan\ account within just one tax year. This can be done as a single distribution of the entire interest, or via multiple distributions over the course of a one-year period. With few exceptions, any designated beneficiary can elect a lump-sum distribution of his or her share of an inherited IRA or plan account, but this approach can have the most undesirable tax consequences of the various post-death payout options typically available.
Roll over the remaining interest
This special post-death option is available only to surviving spouses who have been named the designated beneficiary. In this situation, the surviving spouse’s interest in the inherited IRA or plan account is “rolled over” to the spouse’s own IRA or plan. A surviving spouse can usually go this route regardless of whether the IRA owner or plan participant had begun taking lifetime required minimum distributions (RMDs). Funds rolled into the spouse’s IRA or plan continue to grow tax deferred, and distributions don’t have to begin until the spouse’s own required beginning date. The spouse also can name beneficiaries of his or her choice.
While rather uncommon, any designated beneficiary can even opt to disclaim his or her share of an inherited IRA or plan account.
Factors that influence post-death distribution options
For those inheriting an employer-sponsored retirement plan account, the plan often will specify the post-death distribution options available to the beneficiary. These options may not be as flexible as those permitted under the final IRS distribution rules and you may not be able to elect an alternative payout method to that specified by the plan. You or your financial advisor should consult the retirement plan administrator regarding your post-death options as a beneficiary.
Another factor determining post-death options is the type of beneficiary. Individual beneficiaries generally have more options and flexibility than nonindividual beneficiaries and, even among individual beneficiaries, spouses have additional options not available to non-spousal beneficiaries. The options are far more limited if the deceased IRA owner or plan participant had named his or her estate as a beneficiary or failed to name a beneficiary before death, in which case the estate, by default, becomes the beneficiary. Limited options also apply when one or more charities are named as beneficiary, and special rules apply when it’s a trust that has been named as beneficiary.
Given all the options and factors that can influence them, those inheriting IRAs can benefit from working with a professional to determine which method may be best for them.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Beneficiary distribution options depend on a number of factors such as the type and age of the beneficiary, the relationship of the beneficiary to the decedent and the age of the decedent at death and may result in the inability to “stretch” a decedent’s IRA. Illustration values will greatly depend on the assumptions used which may not be predictable such as future tax laws, IRS rules, and inflation and constant rates of return.
Costs, including custodial fees, may be incurred on a specified frequency as the account remains open.