Inherited IRA and 401(k) Rules Explained
Inherited individual retirement accounts have long been a method to allow non-spousal beneficiaries to inherit an IRA account and to allow the account to continue to grow on a tax-deferred basis over time. In 2007 the rules were changed to allow non-spousal beneficiaries of 401(k) and similar defined contribution retirement plans to treat these accounts in a similar fashion.
Inherited IRA Basics
Spousal beneficiaries of an IRA have the option of taking the account and managing it as if it was their own, including the calculation of required minimum distributions (RMD). For non-spousal beneficiaries, an inherited IRA account can provide them with several options including the ability to stretch the IRA over time by letting it continue to grow tax-deferred. RMDs will apply and the rules are discussed below. (See also: How to Calculate Required Minimum Distributions.)
It is important that IRA account holders who want to leave their accounts to non-spousal beneficiaries work with a custodian who understands the complex rules surrounding these accounts. With most major custodians this shouldn’t be an issue. It is also important that the account beneficiaries become aware of their options in order to ensure that they don’t inadvertently trigger a taxable event. Working with a knowledgeable financial advisor is a good idea in these situations.
The beneficiaries of an inherited IRA have the option of opening an inherited IRA account, taking a distribution, which will be taxable, or disclaiming all or part of the inheritance, which will cause these funds to pass to other eligible beneficiaries. Traditional IRAs, Roth IRAs and SEP-IRAs can be left to non-spousal beneficiaries in this fashion. A 2015 rule change says the creditor protection previously afforded an inherited IRA was ruled void in a recent Supreme Court case. Inherited IRA accounts cannot be commingled with your other IRA accounts though the beneficiary can name their own beneficiaries upon their death. (See also: Tax-Saving Advice for IRA Holders.)
Inherited 401(k) Rules
Prior to a rules change in 2007 the option for non-spousal beneficiaries to put inherited balances for a 401(k), or similar plan such as a 403(b) and others, into an inherited IRA didn’t exist. The rules were changed to allow these beneficiaries to roll their inherited 401(k) balances directly to an inherited IRA account. Some plans will allow non-spousal beneficiaries to leave the balance in the plan and take RMDs over the beneficiary’s lifetime or will allow the beneficiary to leave the money in the plan for up to five years by which time they must either take distributions or roll into an inherited IRA account.
It is important to note this rule did not make the ability to do this a mandatory option for retirement plans to offer. The plan sponsor needs to amend their plan document to allow for these distributions. If this is an option that you are considering for your heirs, you would be wise to check with your company’s benefits department to confirm that this is an option and how to complete the beneficiary designation form. If it is not offered you should ask them to amend the plan accordingly. This is not costly or difficult for them to do. (See also: New Rules for IRA Holders in 2015.)
The rules governing RMDs for inherited IRAs or inherited 401(k)s hinge upon the age of the original account holder at the time of their death. If the account holder had not reached age 70½, which is the age at which RMDs must commence, then the beneficiary can wait until they reach age 70½ to commence taking RMDs. The required percentages will be based on the Internal Revenue Service table in effect for their age at the time.
If the original account holder had reached age 70½ and was taking RMDs, then the beneficiary must continue taking a distribution each year. However, these RMDs will be based upon their age versus the age of the original account holder. This means the distribution amounts will be lower than those of the original account holders (assuming the beneficiary is younger) allowing them to stretch out the account via tax-deferred growth over time. (See also: Avoiding Mistakes in Required Minimum Distributions.)
Unlike with a traditional IRA account, custodians may or may not provide notification as to the amount of the required distribution. As a beneficiary, it's incumbent upon you to stay on top of this as the penalties associated with not taking the distribution are stiff and would apply.
As mentioned above, the Supreme Court ruled that inherited IRA accounts do not offer the same protection from creditors in the event of bankruptcy, a lawsuit or other situations as a regular IRA, 401(k) or other retirement accounts. If you foresee this as an issue for your heirs this might not be the route to go with your IRA or your 401(k) account. Other estate planning vehicles such as a trust might be in order. Consult your financial advisor or estate planning professional. (See also: Designating a Trust as a Retirement Beneficiary.)
As also mentioned above, the beneficiaries of inherited IRAs and 401(k)s cannot commingle these account balances with their own IRA or 401(k). Depending upon the circumstances they may be able to commingle inherited account balances. If they inherited more than one IRA or 401(k) from the same person, they may be able to combine account balances of the same type. For example, they could combine two inherited traditional IRA accounts into one. Again this is complex stuff, so make sure that the custodian understands what they are doing and that you consult with a qualified financial or tax advisor.
Leaving an IRA or 401(k) to a non-spousal beneficiary can allow a younger beneficiary to stretch out the account over a number of years via the fact that any RMDs are taken based on the life expectancy of the beneficiary. These amounts will invariably be lower allowing the account to continue to grow tax-deferred providing an additional retirement benefit for the beneficiary. (See also: Strategic Ways to Distribute Your RMD.)
The rules surrounding inherited IRAs and 401(k)s are complex and subject to mistakes by beneficiaries, custodians and plan sponsors. If you are looking to leave your IRA or 401(k) to non-spousal beneficiaries make sure that you are dealing with a knowledgeable custodian and that you engage the services of a financial advisor who understands these complex rules. Mistakes can result in unwanted tax bills for your heirs.
The Bottom Line
Inherited IRAs and 401(k)s can be a great vehicle for passing assets from these accounts to non-spousal beneficiaries. The rules are complex so it is important to ensure they are followed in order to avoid costly errors. (See also: How Advisors Can Protect Inherited IRAs.)
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