Here’s how to deal with the complicated rules for an Inherited 401 (k) or IRA

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So you inherited a retirement account.

Before deciding when and how to access the funds, you should familiarize yourself with the rules that apply to different beneficiaries. The rules for this retirement plan can be complicated. Hence, mistakes can be made and, depending on the specifics, they can be difficult to undo.

Due to the Secure Act of 2019, your options for dealing with an inherited 401 (k) plan or an individual retirement account now largely depend on your relationship with the deceased. This legislation removed the ability for many beneficiaries to extend distributions over their own lives if the original account holder passed away on January 1, 2020 or later.

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Unless you encounter an exception – for example, you are the deceased’s spouse or minor child – these inherited accounts must generally be used up within 10 years.

Here’s what to know.

Non-spouse with flexibility

If the beneficiary is the deceased person’s minor child, the 10 year impoverishment rule will come into effect once they reach the majority age they live in. In most states, that’s 18 years old.

However, before the child reaches that point, they would need to make the minimum annual distributions, or RMDs as they are called, based on their own life expectancy. (These required withdrawals are typically activated for retirees at age 72 – or 70½ if reached before 2020 – based on the expected lifetime of the account holder.)

“So if you have a 10-year-old taking RMDs, do so by the age of 18 when they transition to the 10-year rule,” said Brian Ellenbecker, certified financial planner with Shakespeare Wealth Management in Pewaukee, Wisconsin.

In addition, a beneficiary who is chronically ill, disabled, or not older than 10 years than the deceased can make distributions based on their own life expectancy and is not subject to the 10-year rule.

All other non-spouse beneficiaries

If you are a beneficiary who is subject to the 10 year impoverishment rule because you do not meet an exception, it is important to consider how you will meet that requirement.

“There is no set amount to take each year. All you have to do is withdraw everything within that 10 year period,” said CFP Peggy Sherman, senior advisor at Briaud Financial Advisors in College Station, Texas.

The process essentially involves setting up an inherited IRA and transferring the money to it. It does whether the original account is an IRA or a 401 (k).

There are several things to consider in this situation, including whether the inherited account is a Roth or a traditional version.

There is no set amount that you have to take each year, it just has to be withdrawn all within those 10 years.

Peggy Sherman

Senior advisor at Briaud Financial Advisors

Distributions from Roth accounts are typically tax-free, while conventional distributions are taxed upon withdrawal. (Note that if you inherit a Roth Account that has been open for less than five years, all income deducted will be taxable, while post-tax amounts brought in will still be tax-free.)

So if it’s a Roth and you don’t pay tax on distributions no matter when you take them in that 10 year period, it may be worth keeping the money there until the 10th year to keep it tax free growing, said Sherman.

However, if it’s a traditional IRA or 401 (k), it’s worth evaluating the tax aspect of the distribution. Since the money would be taxed as normal income, taking a lot at once could put you in a much higher tax bracket. Spreading the dividends over the decade could minimize the tax burden in a given year.

Failure to empty the account within 10 years may result in a 50% penalty on any assets remaining in the account.

In the meantime, heirs are sometimes given a retirement account through an estate – in other words, they weren’t the listed beneficiaries but receive the account when the estate goes through estate proceedings and the assets are distributed.

In this case, different rules apply. The account must typically be used up within five years if the original account holder has not started taking RMDs, according to Vanguard. If RMDs were in progress, the heir would essentially have to maintain these withdrawals.

For spouses

Spouses have more options when they inherit a retirement account.

The first is to roll the money into your own IRA. In that case, you would be following standard RMD rules – that is, when you are 72 years old you start making the necessary withdrawals based on your own life expectancy.

“If the surviving spouse doesn’t need the income, this is probably the best option as they may have time to keep the money in the account growing,” said Ellenbecker of Shakespeare Wealth Management.

However, he said it also means you can get a 10% early withdrawal penalty if you are under 59½ years old and withdraw funds from this account.

The way to avoid this is to put the money in an inherited IRA and remain the beneficiary. In that case, you would not be subject to the penalty. In addition, RMDs – which would be based on your life expectancy – don’t have to begin until the deceased spouse has reached the age of 72, Ellenbecker said.

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