Inherited retirement plans can be very simple and even completely tax-free to transfer, especially when the beneficiary is a surviving spouse. Roth IRAs in particular are excellent vehicles for estate planning, because their contributions had originally been taxed under gross income. However, the situation is more complicated for non-spousal beneficiaries. Inherited retirement plans which are transferred incorrectly and end up as part of the estate can result in very high income and estate taxes.
Spouse as beneficiary
The surviving spouse has the most flexibility and fewest tax penalties when it comes to inheriting a retirement plan. A surviving spouse who inherits an IRA, Roth IRA, or 401(k) may, without tax penalty:
* Roll over the inherited assets into a new IRA or Roth IRA
* Roll over the inherited assets and combine them with current assets in an existing IRA or Roth IRA
* Transfer the inherited assets into an Inherited IRA
* Disclaim part or all of the inherited assets within 9 months of the spouse’s death, which will pass them to the next eligible beneficiary
All age-related restrictions are also reset to the age of the spouse at the time of rollover or transfer.
Non-spouse as beneficiary
All other beneficiaries, including surviving children, are much more limited in their options, and none of those options are entirely tax-free. These beneficiaries may:
* Roll over the inherited assets to a new IRA or Roth IRA, with minimum required distributions beginning by December 31 of the following year
* Take a cash distribution of that share of the inherited assets by way of an Inherited IRA, to be included in gross income
* For a workplace savings plan account, transfer the inherited assets to an Inherited IRA, but leave the assets in the plan
* Disclaim part or all of the inherited assets within 9 months of the spouse’s death, which will pass them to the next eligible beneficiary
Taxes or penalties on IRA distributions will then be calculated as normal. For an Inherited IRA, all age-related restrictions are also reset to the age of the beneficiary at the time of transfer.
Wills, trusts, and retirement plans
If they are not the same, the beneficiary designation on the IRA or 401k form has precedence over the beneficiary designation in a will or living trust. If the will or living trust is changed, it is important to update the beneficiary designation form for the IRA or 401(k) as well. As important inheritance documents, these forms should be filed in the same place as the will or living trust.
In the absence of a beneficiary designation form, the IRA or 401(k) custodian determines the beneficiary according to its standard rules, if any. In case of default, the IRA or 401(k) funds will go to the estate. This outcome can be extremely expensive from a tax standpoint.