Retirement accounts are an important part of the financial assets that many Americans plan to pass on to their families.
But the rules are constantly changing, leaving many people confused about what’s expected of them if they inherit a 401(K) or IRA.
The regulations regarding inheritance of retirement accounts are complex and vary depending on the type of plan and the relationship of the beneficiaries to the original owner.
But experts warn it’s important to understand the rules to avoid shocking tax increases.
The Internal Revenue Service (IRS) requires Americans who inherit retirement accounts to withdraw their savings within a certain period of time, known as required minimum distributions (RMDs).
The rule change has many people confused about what is required if they inherit a 401(k) or IRA.
The rules for inheriting retirement accounts vary depending on the type of plan and the relationship between the beneficiary and the original owner, said Peter Gallagher, managing director of Unified Retirement Planning Group.
“The rules governing retirement plans – 401(K)s and IRAs – are designed to ensure that if an account is inherited, you can’t benefit from tax-deferred growth indefinitely,” Peter Gallagher, managing director at Unified Retirement Planning Group, told DailyMail.com.
“The IRS wants to make sure they get their money back at some point.”
The rules on these withdrawals have changed multiple times over the years, leaving many people confused about their position, Gallagher said.
The original SECURE Act of 2020, and more recently the SECURE 2.0 Act, brought sweeping changes to people who inherit retirement accounts.
According to these rules, most accounts inherited by a non-spouse beneficiary must be liquidated within 10 years of the original owner’s death.
Previously, beneficiaries could “stretch” withdrawals over their lifetime, potentially reducing their tax liability.
For example, people are leaving IRAs to their grandchildren, and because their life expectancy is so long, the IRS isn’t taking as much tax from them, Gallagher said.
However, the new law created an exception allowing certain “qualified designated beneficiaries” to continue to be subject to the stretch IRA rules.
These people include surviving spouses, minors under the age of 21, and people with disabilities.
Generally, IRA owners must take their first RMD by April 1 of the year following the year they reach age 73. That date is called the required start date.
Due to changes in federal law that took effect in 2023, the age at which Americans start taking RMDs may vary depending on the year they were born.
The type of beneficiary of an inherited retirement account and whether the original owner had started taking RMDs at the time of death determine the rules for withdrawals, Gallagher explained.
Most accounts inherited by non-spouse beneficiaries must be liquidated within 10 years of the original owner’s death.
Also, under new rules put in place this year, if the owner of an IRA or 401(K) dies while they’ve already begun taking RMDs, the new owner must take withdrawals annually from years 1 through 9 of the 10-year period.
This additional provision was controversial and caused further confusion, so the IRS announced earlier this year that for the fourth consecutive year, there would be no penalties for not taking these RMDs.
The annual mandatory withdrawal rules do not apply to inherited Roth IRA accounts, regardless of the age of the deceased.
This means that these accounts grow tax-free and can be withdrawn tax-free in the future.
Before planning your withdrawal strategy, Gallagher recommends consulting with a tax professional to be sure you understand the rules that apply to your particular situation.
“One of the most important things for beneficiaries to take away is that when they make a withdrawal, they are almost always subject to tax,” he said.
He recommends keeping an eye on any changes proposed by the IRS and consulting with your certified public accountant (CPA), tax advisor or tax attorney.
This is to ensure that the amount you need to withdraw, combined with any other income you receive, doesn’t put you in a higher tax bracket.
A tax professional may be able to suggest strategies to reduce your taxes each year and avoid taking a big hit, he said.
“It’s going to be a mixed feeling for a lot of people because, firstly, they’ve lost a loved one and, secondly, their taxable income has increased. And people don’t usually complain about it until they get their tax bill and realise they had no idea about the impact it had.”
“Getting the wrong advice can have very disastrous consequences from a tax perspective.”
Gallagher also warned Americans to make sure they have someone listed as a beneficiary on their retirement accounts.
Failure to do so could mean that when someone dies their accounts will be treated as an estate, causing delays and lengthy probate proceedings for family members.
“I always tell people to just have the beneficiary listed as someone, and you can always change it,” Gallagher said.
He suggests consulting a tax professional and choosing to withdraw 1/10 of your money each year.
It’s unclear what tax brackets people will be in going forward, but deferring withdrawals into the ninth or 10th year could mean they’re taxed in a higher bracket, he said.
If you choose to withdraw smaller amounts each year, you spread out the tax impact.
For example, if you inherit a large IRA, you might decide to withdraw $200,000 each year for 10 years, rather than withdrawing $2 million in the 10th year.
