Inheriting the money in someone’s IRA or 401(k) is different from inheriting other property. The IRS has detailed rules about these retirement plans, and if you don’t follow them, you risk losing flexibility and tax benefits.
Spouses get special treatment when they inherit retirement accounts; they get more options than do other beneficiaries. (They may also have a right to claim some or all of the money, even if they were not the named beneficiary.) If you are a beneficiary of your deceased spouse’s IRA or 401(k), you can:
To exercise any of these options, contact the company that administers the account. It will have its own paperwork for you to complete.
Even if you’re under age 59 ½, the usual age at which penalty-free withdrawals are allowed, you can take money out of an inherited account without an early-withdrawal penalty. You will, however, have to pay income tax on what you withdraw.
Only surviving spouses can roll over inherited assets into their own IRAs. If you do this, the money is treated just like your own IRA. You can make contributions to the account and the withdrawal rules are the same as if you had created the account in your name originally. If you’re inheriting a traditional IRA, SEP-IRA, or 401(k), you must roll it over into a traditional IRA; if your spouse named you the beneficiary of a Roth IRA, you can roll it over into your own Roth IRA.
The big benefit is that your required minimum distribution (RMD) is based on your own age—or if you name beneficiary younger than you, on your combined statistical life expectancies. This makes the required annual distribution amount smaller, so that if you wish, you can leave assets in the tax-deferred account to grow. And your RMDs won’t begin until you reach age 70 ½.
If you’re under age 59 ½ and think you’ll need to withdraw money, however, don’t roll over the account. Because the account is treated just as if it were originally your own, if you withdraw money before you’re 59 ½ you’ll be subject to a 10% early withdrawal penalty. If you converted the IRA to an “inherited IRA,” (see below), this penalty would not apply.
You can roll over your spouse’s Roth IRA into your own Roth IRA, and keep making contributions if you are eligible under tax law. There are no required minimum distributions with Roth IRAs, so you don’t have to worry about that part.
Generally, withdrawals from a Roth IRA are not subject to income tax. (That’s because the contributions to the account were made with after-tax dollars, unlike most contributions to traditional IRAs.) However, if you withdraw money from a Roth IRA that hasn’t been open for at least five years, you’ll have to pay an early withdrawal penalty.
You can convert the existing IRA or 401(k) account into what’s called an "inherited IRA." This may be a good idea if you’re not yet 59 ½ and want access to the funds without an early withdrawal penalty.
Whatever your age, you’ll need to take required minimum distributions each year. The amount will be based on your statistical life expectancy. If your spouse was older than 70 ½ at death, you must begin taking RWDs by the end of the calendar year following your spouse’s death. If your spouse was younger than 70 ½, you may be able to wait until your spouse would have turned 70 ½ and been required to make withdrawals. (This can be advantageous if you were older than your spouse.)
If you want to open an inherited IRA, it’s important that you NOT take out money from the account. The transfer must be made directly from the old account to the new one, in what is called a "trustee to trustee" transfer. Otherwise you could owe income tax on the money.
If you don’t need the money and you’d rather it go directly to the contingent (alternate) beneficiary your spouse named, you don’t have to accept it. This is called "disclaiming" the money. You must disclaim within nine months after the death of your spouse and before you take possession of the funds. Once you disclaim, you can’t get the money back if change your mind.
Why turn down money? In certain family circumstances, it can make sense from a tax standpoint. If your spouse named your children (or other younger relatives) as contingent beneficiaries, disclaiming can result in:
Lower required minimum withdrawals. Beneficiaries must begin withdrawing money from the account each year, but the amount of the required minimum distribution (RMD) depends on the statistical life expectancy of the beneficiary. A young beneficiary can take out smaller amounts than an older beneficiary can. That means the money can stay in the account, and taxes can be deferred, for a longer time.
Lower taxes on amounts withdrawn. If the beneficiary is in a lower income tax bracket than the surviving spouse, taxes on distributions will be smaller.
Obviously, the rules governing the inheritance of tax-advantaged retirement accounts are complex—and they change. Before you take any action, and especially before you touch the money in a retirement account you’ve inherited, consult someone with experience with transferring these accounts. Most plan administrators have specially trained advisers who can explain your options; talking to them is a good place to start.