How To Maximize Inherited Retirement Accounts

January 4, 2017 — 11:37 AM EST

For many people, retirement accounts such as an IRA or 401(k) are among their largest assets. When they pass on, leaving these assets to heirs takes some planning both on their end and by the heirs receiving the assets. Here are a few tips help maximize the benefits of inherited retirement accounts.

Traditional IRA accounts

If a spouse is the primary beneficiary of a traditional IRA, they can inherit the funds and treat the account as their own. They are not required to continue to take required minimum distributions if their late spouse was talking them but if they are under age 70 ½. Any taxes or penalties regarding account distributions that would apply to their own account will apply to this money as well. Additionally, the surviving spouse can leave this money to the beneficiaries of their choosing.

For non-spouse beneficiaries, there is the option of an inherited IRA. The rules are a bit different than with a spouse but there are still a number of benefits to this approach. Beneficiaries can still stretch out the tax-deferred benefits of the account by taking only any required minimum distributions.

If the original account owner had already started taking their RMDs, then the non-spouse beneficiary must continue to take them as well. But they are able to take them based on the IRS tables pertaining to their own age. Assuming that they are younger than the original account owner this would result in lower distributions effectively stretching out the account. Note there is a proposal floating around to mandate that all money from an inherited IRA be distributed within five years, but there is nothing pending at this time.

Roth IRA accounts

One of the advantages of a Roth IRA is that if certain requirements are met, withdrawals are tax-free. Additionally, there are no required minimum distributions at age 70 ½ with a Roth IRA which makes this an excellent estate planning vehicle. You can let the account continue to grow tax-free for your heirs.

A Roth IRA can be left to a spouse and he or she can treat it like their own account just like with a traditional IRA account. Non-spousal heirs will need to take RMDs from the account, but the distributions are not taxable.

401(k) accounts

A 401(k) can be passed to a spouse and then he/she can treat it like their own IRA. Non-spouse beneficiaries must be allowed to roll the balance of the plan to an inherited IRA if they are the primary beneficiary. Plans can force secondary beneficiaries to take a distribution within five years, minimizing any ability to stretch the balance.

A Roth 401(k) does have required minimum distributions but they are tax-free. It may make sense to roll your balance in a Roth 401(k) to a Roth IRA once you leave your employer to avoid this.

A few mistakes to avoid

IRAs and other inherited retirement accounts can be tricky to deal with and beneficiaries can cause themselves expensive headaches if they don’t follow the rules, even inadvertently. Here are a few things to be aware of:

  • Make sure that all RMDs were taken by the original account holder. This issue can arise in the year of their death. The penalty of 50 percent of the untaken amount still holds.
  • Make sure that the custodian transferring the account balance and the custodian receiving the money in an inherited IRA both know what they are doing. Slip-ups here are not uncommon and can cost you heavily on taxes and losing out on the opportunity to stretch the account.
  • Make sure that you take all RMDs from the inherited account on time.
  • If you opt to keep inherited 401(k) assets in the plan be sure to understand the plan’s rules for non-spousal beneficiaries. Plans are not required to allow you to stretch the account and may require you to remove all the assets within five years.
  • Commingling an inherited IRA with your other IRA account(s). Inherited IRA funds must not be commingled with other assets.


The Bottom Line

Retirement accounts can be a great way to pass money to your heirs. But the transfer of these assets can be fraught with opportunities for error that, in some cases, can trigger unnecessary taxes and even “blow-up” the tax-deferral of the account.

For those who plan to leave their retirement assets to heirs, be sure that all of your ducks are in a row including beneficiary designations and knowing and communicating all rules and requirements from the custodian of the funds to your heirs if possible.

For those inheriting a retirement account, it is extremely important to understand and follow all requirements in order to maximize the benefit of this asset.