Inheriting Retirement Accounts: Legal Overview

Tax-advantaged retirement accounts are subject to different rules than are other inherited assets. Here are the basics.

Lots of people leave money in their retirement plan accounts—and it’s not always clear who inherits these funds, or how they should best handle them. Here are the basics.

In the Estate or Not?

Most people name beneficiaries for their IRAs, 401(k)s, and other retirement plan accounts. Typically, the account custodian or employer supplies the paperwork when the account is set up, and it’s a simple matter of filling in the beneficiaries’ names. Most plans allow account owners to designate both a primary beneficiary and also a contingent (alternate) beneficiary, who would be entitled to the funds if the primary beneficiary didn’t survive the account owner. It’s common, for example, for someone to name his or her spouse as the primary beneficiary and the children as contingent beneficiaries.

If a beneficiary was named, then the account funds do not have to go through probate, and the executor of the estate is not in charge of them. It’s up to the beneficiary to claim the money from the company that holds the account.

If no beneficiary was named, or the estate was named as the beneficiary (uncommon), then the funds may be part of the probate estate, and it’s the executor’s job to deal with them. They pass under the terms of the deceased person’s will or, if there’s no valid will, under state intestate succession law.

General Rules for Beneficiaries

A beneficiary can take out all the money from a retirement account immediately—but depending on the kind of account, may have to pay income tax on it in the year in which it’s withdrawn. (This is in contrast to other money inherited from other sources, which isn’t taxed as income.)

If the beneficiary doesn’t need all the money right away, it can be better, from a tax standpoint, to let it stay in the retirement account for a while. For traditional retirement accounts, taxes are deferred until the money is withdrawn. (See “Tax Benefits of Retirement Plans ,” below.)

In most cases, a beneficiary’s options depend primarily on these factors:

  • The kind of retirement account. Different kinds of plans—traditional IRA, Roth IRA, 401(k), and so on—are governed by different rules when it comes to taking money out after the account owner dies.
  • The beneficiary’s relationship to the deceased person. Surviving spouses sometimes have a right to claim money in a retirement account, even if someone else was named as the beneficiary. They also have more choices, when they inherit retirement accounts funds, than do other beneficiaries.
  • How old the deceased person was. After age 70 1/2, people must make mandatory annual withdrawals from their traditional retirement accounts, and that affects the beneficiary as well.
  • How many beneficiaries were named. If there's more than one, special rules apply.

Tax Benefits of Retirement Plans

By contributing money to a conventional IRA or 401(k) plan, it’s possible to put off paying taxes until retirement, when most folks expect to be in a lower income tax bracket. The tax break comes because most contributions to these accounts are made with pretax dollars (401(k) plans) or are tax-deductible (IRAs). If the contributions grown when invested, the increase in value isn’t taxed until the account owner—or, after the account owner’s death, a beneficiary—withdraws the money. There’s really a double benefit, because the money that would have otherwise gone to pay taxes is invested, over the years, to help grow the account.

Roth IRAs and 401(k)s operate on a different principle. Contributions are made with after-tax money, but when the money—including money from investment of the contributions— is withdrawn, it isn’t subject to tax. In other words, all the growth is tax-free.

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