Inherited IRAs and 401(k)s can be a great vehicle for passing assets to non-spousal beneficiaries but you have to know the basic rules so that these assets are not overtaxed or exposed to the claims of creditors.
Inherited individual retirement accounts have been a common way to let non-spousal beneficiaries inherit an IRA account and allow the account to continue to grow on a tax-deferred basis in the future. These rules were changed in 2007 to allow non-spousal beneficiaries of 401(k) and similarly defined contribution retirement plans to treat these accounts the same way.
Spousal beneficiaries of an IRA have the option of taking the account and managing it as if it was their own. This includes the calculation of required minimum distributions (RMDs). For non-spousal beneficiaries, an inherited IRA account can give them a few options, including the ability to stretch the IRA over time by letting it continue to grow tax-deferred.
IRA account holders who want to leave their accounts to non-spousal beneficiaries should enlist the help of an estate planning attorney who understands the complex rules surrounding these accounts. The account beneficiaries must be careful to ensure they don’t inadvertently trigger a taxable event.
The beneficiaries of an inherited IRA can open an inherited IRA account, taking a distribution (which will be taxable), or disclaiming all or part of the inheritance (causing the funds to pass to other eligible beneficiaries). Traditional IRAs, Roth IRAs, and SEP IRAs can be left to non-spousal beneficiaries in this way. A 2015 rule change says the creditor protection previously afforded an inherited IRA was ruled void by the U.S. Supreme Court. Inherited IRA accounts can’t be commingled with your other IRA accounts, but the beneficiary can name their own beneficiaries upon their death.
The rules for RMDs for inherited IRAs or inherited 401(k)s are based on the age of the original account holder at the time of his or her death. If the original account holder had reached age and was taking RMDs, then the beneficiary must continue taking a distribution each year. However, the RMDs will be based on their age, not the age of the original account holder. As a result, the distribution amounts will be less than those of the original account holders (assuming the beneficiary is younger). This lets him or her stretch out the account via tax-deferred growth over time. One point of clarification: the only way to avoid having to take RMDs annually, even if the account holder had not reached the age of 70½ and therefore did not start RMD distribution is if the IRA is a spousal IRA. The IRS rule require any other inheritor to begin their RMDs regardless of their age or the age of the original account holder.
These rules are complicated, so work with an estate planning attorney to be certain they’re followed to avoid costly errors. We can help you navigate these complicated rules; simply give us a call at 757.259-0707 or a complimentary consultation or "request a consultation" online.
Reference: Investopedia (December 18, 2017) “Inherited IRA and 401(k) Rules Explained”