Employer sponsored plans such as 401(k)s, 403(b)s, and 457(b)s are typically the first stop when saving for retirement. Tax benefits, high contribution limits, and ease of use are all contributing factors in their popularity. Because of this, it is not uncommon to retire with a majority of savings inside one of these plans. As employer plans and IRAs were designed to pay for retirement, there are substantial changes to their structure as they transition to a new owner. Knowing how these assets are treated after death is crucial to setting beneficiaries up for success. Depending on who you're leaving your assets to, they may have limited options.
To keep things simple, I will be referring to all types of tax deferred retirement accounts (including employer plans) as IRAs.
If a spouse is listed as the beneficiary of an IRA, they have several flexible options to choose from. The most commonly used is to combine the inherited account with their own IRA. In doing so, the Required Minimum Distribution (RMD) is applied at age 72 for the total amount currently in the account. This provides a benefit should the inheriting spouse be younger than the deceased as the RMD is then applied at a later date.
Should the surviving spouse be older, the inherited IRA is often left unchanged with no transfer of ownership. This allows RMDs to be deferred until the deceased spouse would have turned 72. The surviving spouse still has full access to the funds with the added benefit of continued RMD deferral.
The surviving spouse also has the option to take distributions over their lifetime similar to the stretch IRA provision available before the passing of the SECURE Act. This would allow for annual distributions from the IRA with no early withdrawal penalty, meaning it could be an attractive option for an additional source of income should a spouse pass away early in life.
There is also the option to withdraw all the funds over a 5-year period, but this is a rare election as the tax burden is often too high.
A non-spouse such as a child, sibling, parent, or unrelated party, faces more restriction when inheriting an IRA. For accounts inherited prior to 2020, those individuals had the option to distribute the account over their lifetime. Any IRAs inherited after 2019 no longer have that option. Instead, the entire account must be distributed within 10 years. Withdrawals over that time can be made in any amount during any time, but the last dollar must be taken within that 10 year window or the owner is subject to steep penalties. Depending on the type of account (Traditional vs Roth) the dollars withdrawn could have a substantial impact on a beneficiary’s taxes. We wrote about Roth Conversions here.
For those who are charitably inclined, leaving assets to charity is typically best done through IRA beneficiary designations. The charity will receive the full amount without either party paying income taxes, and the donated portion can be deducted to reduce possible estate taxes. There is currently an ongoing discussion around estate tax law that may change this argument but, as of now, the best dollars to donate come from Traditional IRAs.
There are endless and forever changing laws around IRAs and 401(k)s not only during one’s life, but also well afterwards. Trusts, Wills and Power of Attorney are extremely useful tools to help ease the transition of assets at death, but having a firm grasp of the basics is invaluable. Understanding the impact of how beneficiaries can utilize your hard-earned savings is crucial to developing an appropriate estate plan, and making sure the right people and organizations get their share.
Joe Crowley, CFP® is an Investment Advisor at Exchange Capital Management. The opinions expressed in this article are his own.