If you recently inherited retirement assets from a loved one, pay attention to the IRS rules governing this type of bequest.
Your options for handling this money depend on your relationship to the deceased and the type of retirement account (401(k) or 403(b) plan, IRA, or annuity) inherited.
When inheriting a deceased spouse's employer-sponsored plan account, you don't have to pay income taxes if the assets are left in a tax-deferred account. After age 70 ½, however, you must begin required minimum distributions (RMDs) based on your life expectancy. How to calculate RMDs, which are taxed as ordinary income, is shown in IRS Publication 590. It's usually better to use this withdrawal schedule than cashing out the entire account at once, which may trigger higher income taxes to you in the year you withdraw it.
If the deceased wasn't your spouse, the plan's rules generally determine your options. Depending on the plan, you may have these options: leave the money in the plan, transfer the money to an IRA created for this purpose, or elect a cash distribution.
Some employer plans offer non-spousal beneficiaries the option of a trustee-to-trustee transfer from the employer-sponsored plan to an IRA. The IRA is opened in the decedent's name for the beneficiary's benefit, and assets transferred to the IRA cannot be comingled with other IRAs. The non-spousal beneficiary must take annual RMDs based on their own life expectancy.
Alternatively, employer plans can default to a five-year payout rule and require non-spousal beneficiaries to empty the account within five years of the death of the deceased. Distributions taken by non-spousal heirs are taxed as ordinary income.
When inheriting a traditional IRA from a deceased spouse, you may treat the inherited IRA as your own. You can transfer those assets to your existing IRA. Such transfers usually don't trigger tax payments if you follow the rules for trustee-to-trustee transfers. You may begin taking distributions at age 59 ½, and with a traditional IRA, after age 70½, you must take annual RMDs, based on your life expectancy. Those withdrawals are taxed as ordinary income.
If the deceased wasn't your spouse, you cannot transfer the inherited IRA assets to your existing IRA. Instead, you have two options: take all distributions within five years of the decedent's death, or take annual distributions based on the life expectancy of you or the decedent, whichever is longer.
If you inherit an annuity, the tax status of periodic payments to you is determined by how much the decedent paid for the annuity contract, which is known as the cost basis. Amounts distributed to you up to the cost of the contract are not taxable, but amounts distributed over the deceased's cost are taxed as ordinary income. The IRS usually treats distributions as coming from the excess over cost first until used up.
Before taking any action, with inherited retirement assets, it is critical to consult a tax adviser or financial planner to be sure you are avoiding unnecessary taxes.
Karin Grablin, a financial adviser with SRQ Wealth Management in Sarasota, can be reached at 941-556-9004.