A retirement account can be a great gift and a good estate planning tool. But trying to figure out what to do with it can easily turn into a daunting task. The details of how you can receive the inherited money depend on a number of variables, including your relationship to the original account owner, the type of plan inherited (IRA, Roth, 401(k), etc), the age of the deceased, and, with the SECURE Act, whether the original account owner passed away in 2019 vs. 2020 or later (take a look at the IRS page here to get an idea).
Luckily, your options are relatively simple and only depend on a few key principles, which we analyze here. The rest is only details of implementation; the details may be important but aren’t likely to drive your decisions.
Your Options for Retiring (Austin Texas)
You really have four basic options when it comes to receiving inherited retirement money:
- Treat the account as your own;
- Treat yourself as the beneficiary of the inherited IRA;
- Take the money now as a lump-sum;
- Disclaim the account.
A good guiding principle is to choose the option that lets us get the most out of the inherited gift, after considering taxes, our financial goals, and our needs.
Economics
Choosing the right option depends on your needs, goals, and financial situation. Generally, you want to choose the option that increases the amount of resources for your goals. In the case of an inherited IRA, we achieve this by reducing the taxability of the proceeds while taking advantage of the tax-deferred or tax-free growth that the retirement account can provide.
Suppose you have inherited a Roth IRA and you are not disclaiming the account. If you are the spouse of the deceased you can decide to use the Roth IRA as your own (option 1). This means that the account will be considered as if it had always been your account, subject to normal Roth IRA rules that depend on your age. Most notably, contributions can be withdrawn tax-free, at any time! Earnings can be distributed tax-free too, provided they qualify (based on your age and a 5-year holding period rule). The Roth is definitely the best type of account to inherit; consider this when you make your estate plans.
Inheriting a Roth and why you should discuss with a Wealth Management Fee Only Fiduciary
With the Roth, option 3 (take the money now) can be justified if you have an immediate liquidity need. If you need the cash, the distribution can be 100% tax-free, if the earnings on the account satisfy the 5-year holding period rule. If you treat yourself as the beneficiary (option 2), you can take distributions (potentially 100% tax-free) any time you need, but you will also be required to take certain distributions, using the same rules that apply for traditional IRAs and 401(k)s. Yes, required distributions apply for a Roth account too, if it’s inherited.
For a spouse beneficiary, you have to start taking distributions based on when the deceased owner would have reached 70 ½ (or 72 if passed away after 2019). The amount of the minimum distribution is based on your life expectancy. If the beneficiary is not a spouse, the same rule applies only if the deceased passed away before the end of 2019. Otherwise, the entire amount will have to be withdrawn within 10 years from having inherited the account, with no additional requirement over the 10 years. In all of these cases, the money left in the inherited Roth IRA will grow tax-free, for up to 10 years (non-spouse) or longer (spouse).
As the spouse, when would you choose the inherited IRA instead of treating the Roth as your own? The inherited route may be for you if you think you need to make withdrawals that would not be qualified distributions if the Roth was your own (see here for a discussion of Roth IRAs).
Traditional IRA and 401(k) accounts
The options are the same as in the Roth example. The difference is in the taxability of the distributions from the accounts. Any distribution, required or not, is considered as ordinary income. Taking a lump-sum is rarely optimal, except for small amounts at low-income brackets, and if liquidity is needed. Large lump-sum amounts can result in an increase in your tax bracket, and there is a mandatory 20% withholding on the amount. If you treat the account as your own (option 1), which is only available to spouses, it means that your own retirement account will increase by the amount you inherited. This could be a good choice for someone who does not need to withdraw until retirement. The inheritance just increased their retirement savings, and they can devote future saving resources to other goals.
Option 2, being the beneficiary as the inherited IRA, can be used by spouses (or non-spouses, if the original owner died before the end of 2019) to withdraw some regular income from the account while leaving the remaining assets to grow tax-deferred, to be used later as a source of retirement income, for example. For non-spouses, the tax deferral is limited to 10 years, but the benefit is still there.
Withdrawing from an inherited IRA, talk to a Financial Advisor in Austin TX
If option 2 is chosen, how should someone withdraw over time? Because any withdrawal is taxed as ordinary income, we need to consider the effect of the withdrawal on the marginal tax rate. Consider the non-spouse, 10-year horizon. Except for the lowest tax brackets, the growth benefit from deferring the withdrawal for 10 years is unlikely to offset a bump in the marginal tax rate. So, waiting 10 years to withdraw everything from the account is not optimal. A better choice is to smooth out the withdrawals, moving back from year 10, to minimize the impact on the marginal rate while retaining some of the tax-deferral benefit. In the case of a spouse, the choice may be between the need to make periodic withdrawals and building future retirement wealth, which is best considered within a comprehensive plan.
A 401(k) plan works similarly to a traditional IRA. You can treat the 401(k) as your own by rolling it over the account to your own IRA if you are the spouse (option 1), or use the other options as for the IRA. Finally, when would someone disclaim the inherited account (option 4)? Common reasons are to reduce taxation, make the assets available to other beneficiaries, or to even things out among multiple beneficiaries. If you think disclaiming the account may be for you, make sure to follow the rules specified here.
While the details of calculating taxable amounts and required distributions can be quite complex, the choices you have are relatively straightforward, as summarized below.
| Choice | What it means | Who can use |
| 1. Treat as your own | Same rules as your own IRA apply | Spouse only |
| 2. Inherited IRA | Can take distributions any time, with taxability depending on the type of account. | Spouse; non-spouse |
| Required distributions can be based on your life expectancy, with start date based on the age of the deceased. | Spouse; non-spouse (if deceased in 2019 or earlier) | |
| 10 Year Rule | Non-spouse (if deceased after 2019) | |
| 3. Lump-sum | Taxable depending on the account type | Spouse; non-spouse |
| 4. Disclaim the account | You are no longer the beneficiary | Spouse; non-spouse |
As always, the best choice depends on your goals, needs, and current financial situation, so talk to us or a trusted financial planner if you have any questions.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
