Tax implications of inherited retirement accounts

Tax implications of inherited retirement accounts

To help mitigate the tax consequences of inheriting a potentially large pre-tax retirement account, the Internal Revenue Code permits spouses to roll an inherited retirement account over to his/her own IRA. Meanwhile, other non-spouse beneficiaries are permitted to at least stretch distributions out over their life expectancy as well.

The favorable rules for a so-called stretch IRA, however, do not automatically apply to all inherited retirement accounts. In the case of an inherited employer retirement plan, such as an inherited 401(k) or inherited 403(b) account, the employer has the option to force non-spouse beneficiaries to use the far-less-favorable 5-year rule instead, compelling the entire account to be liquidated by the end of the 5th year after death.

Fortunately, though, employer retirement plans are required since 2010 to at least permit a nonspouse designated beneficiary to complete a trustee-to-trustee transfer to an inherited IRA, preserving the ability to complete a stretch. On the other hand, the transfer provisions are only available to the original beneficiary of the inherited employer retirement plan, and not any successor beneficiaries who can continue the stretch if available, but only from the original account.

On the plus side, the rules permitting a transfer from an inherited employer retirement plan to an inherited IRA also allow the assets to be shifted to an inherited Roth IRA, effectively giving the beneficiary the option of doing a Roth conversion even after the death of the original account owner.

This is a strategy uniquely available to beneficiaries of inherited employer retirement plans, as an inherited IRA may not be converted to a Roth.

This is a strategy uniquely available to beneficiaries of inherited employer retirement plans, as an inherited IRA may not be converted to a Roth. The caveat, however, is that just because it’s possible for a beneficiary to convert, doesn’t mean it’s wise to do so. After conversion, an inherited Roth IRA still has required minimum distribution obligations, and it will usually be preferable to convert any other type of pre-tax retirement account first.

View the full article at Financial Planning.