How to Inherit Retirement Assets in California
Retirement accounts, unlike almost any other asset that a person can inherit, are subject to income tax. That means that if you inherit an IRA or a 401(k), when you withdraw the money, you'll have to pay income tax on these withdrawals.
From the government's point of view, this makes a certain amount of sense. These are, after all, tax-deferred accounts. The decedent saved that money while he or she was working, didn't pay taxes on that money, and would have had to pay income tax on the assets when they withdrew them. So, if someone leaves you an IRA, and you withdraw the money, the government doesn't want to lose out on that deferred tax revenue. (This is a slight simplification of a complicated set-up, and some plans also hold after-tax contributions, which are not taxed upon withdrawal, but that's not the usual scenario.)
Retirement assets, like life insurance, pass to designated beneficiaries, not by Will or trust. So, the first thing to determine is who the beneficiaries are. The next step is to determine how old the decedent was, and whether or not they'd already begun taking out the required minimum distribution annually. Finally, you'll need to determine what your options are for withdrawing the money over time.
Surviving spouses have different options than other beneficiaries. Everyone else, though, has to begin drawing money out by the end of the year after the plan owner's death (or sooner, if the owner was older than 70 1/2 and had already begun mandatory required minimum distributions). Non-spouse beneficiaries cannot contribute to an Inherited IRA and cannot roll an IRA over, but instead have to keep the IRA as an Inherited IRA.
Withdrawal rules are complex, and vary by plan providers (the government sets withdrawal rules, but any given plan doesn't have to offer all of them). The plan provider, though, will give you the available options, once they determine who the beneficiaries are, and how old the decedent was. In theory, it sounds really complicated; in practice, once you contact the plan provider and identify yourself as a beneficiary, they'll tell you exactly what your options are.
Generally, most beneficiaries have one or more of these three options when it comes to withdrawing the money in an Inherited IRA:
- Withdraw everything right away.
- Withdraw everything within five years after the death.
- Withdraw everything over a beneficiary's life expectancy.
Of the three, the most tax-efficient one by far is the third: the slower you withdraw the money, the more time you have to generate tax-deferred growth in that account and the less tax you have to pay each year on these distributions, which count as income, which often means that your income tax rate stays below the maximum.
However, not all plans permit such "stretch-out" planning, and not all beneficiaries are entitled to it. Under IRS rules, only certain beneficiaries, called "Designated Beneficiaries" are entitled to stretch-out planning. Basically, this means individuals, and certain trusts.
If a charity is named as a beneficiary in addition to individuals, everyone has to withdraw the money immediately, or within five years. If you are dealing with this situation, discuss your options with the plan administrator. If the charity is paid out by September 30th of the year following the death, they no longer count towards the list of "Designated Beneficiaries" and the remaining individuals may be able to do stretch-out planning. (The rules are complicated!)
Still, it's worth trying to stretch-out withdrawals if you can. Sadly, very few beneficiaries do, as it turns out. But it is financially worthwhile.
For example, Chandler dies at age 72 with an IRA worth $300,000. He leaves the IRA to his son, Jay, who is 40 years old. If Jay withdraws the $300,000 immediately, it will count as taxable income to him, in addition to his 75K in salary, and he will owe over $100K in federal income tax (plus state income taxes) at the maximum federal tax rate.
If, instead, Jay takes the money out over his expected lifetiime, he will be required to take out only $7,000 in the first year, and he'll owe only about 17K on his adjusted gross income of $82K, at a lower tax rate. If Jay decides to take out more money in any given year, he can do so. He's only required to take out a minimum distribution, based on his age, each year.
If more than one beneficiary is named, check with the plan administrator and try and get the plan split up into separate accounts for each beneficiary by December 31 of the year after death. That way each beneficiary can use their own life expectancy to calculate required withdrawals, rather than the oldest beneficiary's age.
If no beneficiary is named (or the named beneficiary has already died), than the plan funds go either to the decedent's estate, or to the surviving spouse, it depends on the plan's rules. If it goes to the estate, the funds will be distributed as part of a probate proceeding, and, because no "Designated Beneficiary" was named, all of the money will need to be withdrawn within five years, or over the decedent's life expectancy (if the decedent died over age 70 1/2).
Roth plans are different from IRA's and 401(k)'s because the taxes have already been paid on the contributions made during life. The owner of these plans has no required minimum distributions to make during their lifetimes. That means that they can leave the whole account to their loved ones. However, the beneficiaries do have to start making these required withdrawals, under the same rules as a regular Inherited IRA.
Surviving spouses can do a rollover with a Roth IRA, just as they can with a regular IRA. Everyone else, though, has to start withdrawing the money, starting December 31 of the year after death. Failure to take out these required distributions can result in a 50% penalty of what should have been distributed.
If the Roth IRA was opened less than five years prior to a person's death, the beneficiary will have to pay taxes on the earnings withdrawn before five years has passed since the account was opened.
You inherit a Roth IRA that was established two years earlier. The Roth IRA includes $106,000 from a rollover contribution and $6,000 of earnings. You can immediately withdraw the entire $112,000 and pay tax (but no penalty) on the $6,000 of earnings. Or you can withdraw up to $106,000 (paying no tax or penalty) and leave the $6,000 of earnings in the Roth IRA for three more years, when you can withdraw the balance of the Roth IRA tax-free.
You may also be interested in:
Small estates don't have to go through probate to be distributed. Find out what California's limit is for this small estates procedure.
Learn how to find and claim proceeds under life insurance policies.
Joint tenants automatically inherit an asset when the other joint tenant dies. Learn more about how joint tenancy assets are distributed.