Inherited Retirement Accounts and the Clock
Last week's short list had one item I called the exception to slowing down: learning the rules on inherited retirement accounts. This week is that item.
Over the years, I've met people who cashed out an inherited IRA or 401(k) in one shot. It usually happened in the first few weeks. A form arrived, one box offered the full balance, and checking it felt like one less thing to manage. Then tax season came. Every dollar counted as income in a single year, stacked right on top of their paycheck.
Names and details changed. This is a blend of situations I've seen.
No one did anything reckless. They just didn't know these accounts come with their own rules, and a clock.
Why these accounts are different
Money in a traditional IRA or 401(k) usually hasn't been taxed yet. Your parent got a tax break putting it in. The tax comes due when the money comes out, and now that's you.
A Roth account works differently. Withdrawals are often tax-free, though the timing rules still apply.
Who you are changes the rules
The rules depend mostly on your relationship to the person who died.
- A spouse usually has the most options, including treating the account as their own.
- Most other heirs, like adult children, generally must empty the account by the end of the tenth year after the year of death. If your parent had already started required withdrawals, you may also need to take some out each year along the way.
- A few others, such as a minor child of the owner, someone disabled or chronically ill, or someone close in age to the owner, may have more flexible options.
If the account went to a trust or the estate instead of to you by name, the rules can change again. That's a question for the attorney.
Three things to avoid
- Taking a check to "move it later." For most heirs, money paid out to you can't be put back. The usual way to move it is a direct transfer into an account titled as an inherited IRA.
- Cashing it out before you see the tax bill. It may still be the right call for you. Just make it with the numbers in front of you.
- Missing a required withdrawal. The IRS can charge a penalty. And if your parent hadn't taken this year's required amount before they died, that one may fall to you.
Take extra care with an annuity
Sometimes the retirement account holds an annuity, which is a contract with an insurance company. When that's the case, slow down even more.
The insurance company usually sends its own claim packet, separate from any bank or brokerage paperwork. It's often a thick stack of forms, and I've seen it overwhelm smart, capable people. Buried in those pages is a list of options. Take the full amount. Take payments over time. Keep it growing inside an inherited IRA. Some of those choices are hard to undo, and one checked box can pay the whole thing out as taxable income in a single year.
Some annuities also include a death benefit, so the amount you can claim may differ from the last statement. Before you sign anything, ask the insurance company to walk you through every option in plain words, and have a professional look at the packet with you.
If you need all of it out
Sometimes emptying the account is the right call. Maybe you need the money for a home, or you'd rather not manage another account. Even then, timing matters.
Here's a move I often look at with people. Instead of taking it all at once, we take part of it out late in the year, in November or December. Then we take the rest in January. Same money, same account, just a few weeks apart. But now the income lands across two tax years instead of one, which can keep more of it out of the higher brackets.
It's a simple idea, and it's easy to miss when a form is sitting in front of you with one box that says "full balance." Whether it makes sense depends on your income in each of those years, so run the numbers with a tax professional first.
The good news in the clock
Ten years sounds like pressure. I see it as room. It gives you time to spread withdrawals out instead of taking one big tax hit. Years when your income dips, like a job change or the early years of retirement, can be good years to take more. That's the kind of plan worth building with a CPA and an advisor at the same table.
You don't have to build that plan this week. You just need to know which rules you're under, so the clock doesn't make the choice for you.
One small next step
Find out three things about each inherited retirement account. Is it traditional or Roth? Did it come to you by name, or through a trust or the estate? Had your parent started required withdrawals? Write the answers down and bring them to your first conversation with a CPA or advisor.
Next week, in Post 5, we'll stay on taxes for one more stop: New Jersey's inheritance tax, the one most families here don't see coming.
This post is general education, not individualized tax advice. Talk with a tax professional about your situation.
Securities and Advisory services offered through LPL Financial, A Registered Investment Advisor, Member FINRA/SIPC.
