How to handle complicated rules for an inherited 401 (k) or IRA

So you inherited a retirement account.

Before making decisions about when and how to access money, it is worth getting acquainted with the rules that apply to different beneficiaries. The rules for these retirement plans can be complicated. Therefore, mistakes can be made and, depending on the specific, they can be difficult to undo.

Thanks to the Secure Law of 2019, your options for managing an inherited 401 (k) plan or an individual retirement account now largely depend on your relationship with the deceased. This legislation eliminated the ability of many beneficiaries to extend distributions over their lifetime if the original account owner died on or after 1 January 2020.

More from personal finance:
The way in which social security benefits are treated at death
Avoid these mistakes by going over a 401 (k) to an IRA
Here are some money-making mistakes to avoid in divorce

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

Here’s what you need to know.

If the beneficiary is the minor child of the deceased, the 10-year exhaustion rule applies once they reach the age of majority in which they live. In most states, this is the age of 18.

Before reaching this point, however, the child should take the required minimum annual distributions or RMDs as they are known, based on their own life expectancy. (Those required withdrawals are usually started for pension savers at the age of 72 – or 70½ if they are reached before 2020 – based on the expected life of the account owner.)

“So if you have a 10-year-old who takes RMDs, he would do that until he’s 18, when he turns 10,” said Brian Ellenbecker, a certified financial planner with Shakespeare Wealth Management in Pewaukee, Wisconsin.

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

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

“You don’t have to take a set amount every year, you have to withdraw it within 10 years,” said CFP Peggy Sherman, senior advisor at Briaud Financial Advisors in College Station, Texas.

The process basically involves setting up an inherited IRA and transferring the money to it. This is the case if the original account is an IRA or 401 (k).

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

Distributions in Roth accounts are generally tax-free, while traditional ones are tax-deductible. (Please note that if you inherited a Roth account opened less than five years ago, withdrawn earnings would be taxable, while after-tax taxpayers would still be tax-exempt.)

So if it’s a Roth and you don’t pay distribution taxes, no matter when you take them in that 10-year period, it might be worth leaving the money there until year 10, so that it can continue to grow tax-free, said Sherman.

On the other hand, whether it is a traditional IRA or 401 (k), it is worth assessing the fiscal aspect of taking over distributions. Because money would be taxed as ordinary income, taking a lot at once could hit you in a much higher tax category. Dividing distributions over the decade could reduce the impact of the tax in a given year.

If you do not clear your account within 10 years, the remaining assets in your account could be subject to a 50% penalty.

Meanwhile, sometimes the heirs arrive with a retirement account through an estate – in other words, they were not the mentioned beneficiaries, but they arrive with the account when the estate goes through probation and the assets are distributed.

In this case, different rules apply. Generally, the account must be exhausted within five years if the original account owner has not started taking RMDs, according to Vanguard. If RMDs were in progress, the heir should essentially maintain these withdrawals.

Husbands have more options when inheriting a retirement account.

The first is to raise the money in your own IRA. In this case, you will follow the standard RMD rules – that is, when you reach the age of 72, you start making the necessary withdrawals based on your own life expectancy.

“If the surviving spouse doesn’t need income, it will probably become the best option because it can give them time for the money to continue to grow in the account,” said Ellenbecker of Shakespeare Wealth Management.

However, he said, this also means that you will be subject to an early withdrawal penalty of 10% if you are under the age of 59 ½ and withdraw money from that account.

The way to avoid this is to put the money in an inherited IRA and remain the beneficiary. In this case, you would not be punished. In addition, RMDs – which would be based on life expectancy – should not begin until the deceased husband is 72 years old, Ellenbecker said.