Inheriting a Parent’s Retirement Account

Inheriting a Parent’s Retirement Account

Managing financial decisions may seem overwhelming, particularly after you’ve lost a loved one. Here’s an introduction to what you need to know as a beneficiary inheriting a parent’s pre-tax 401(k) account.

First, you’ll need to complete the paperwork necessary to transfer ownership. This is also when you’ll designate your own beneficiaries for this new Inherited IRA. If you haven’t done so already, notify the institution that owns your parent’s retirement account and provide a copy of the death certificate. In turn, they’ll send you a series of paperwork that needs to be completed to accept the inheritance.

Secondly, you’ll want to allocate the assets according to your investment needs and goals. Think about your willingness and ability to take on market risk, your goals, and of course the limited span these assets can be invested in this particular account. This gets me to the undesirable 10-year-rule.

Federal tax law was recently amended to force many beneficiaries to receive full distribution of inherited accounts much earlier than under prior law. You’ll need to withdraw the entire amount inherited, and any earnings on those amounts, by the end of the tenth year following your parent’s death. You can take distributions in whatever time period you want as long as it’s all taken by year 10 (no RMDs needed). For example, you could wait 9 years then take it all in year 10 or take distributions every other year, or only when a full moon appears, you get the idea.

Exception: different rules apply for a disabled or chronically ill person (or a trust for their benefit) or minor child of the account holder.

So, your final step is to prepare for account liquidation. Since Mom or Dad made tax-deferred contributions to this account, each withdrawal you make is taxable as ordinary income. That includes the contributions as well as the growth they’ve experienced in the account. Your tax liability will increase each year that you receive withdrawals so mindful planning is necessary. Luckily there is no early withdrawal penalty of 10% for accessing these assets before you reach age 59 ½. But current marginal tax rates are important when considering liquidating a taxable asset, as well as having a clear understanding of goals in the future that may impact your income.

This is where financial planning and tax planning come in. It may or may not make sense to spread the distributions evenly. Consider these examples. If your children are in high school when you inherit this money, you’d need to keep in mind that the FAFSA looks at the previous two years’ worth of income. Alternatively, if you are close to retirement when you inherit the money, you may want to delay taking the distributions until you’re retired on a lower income. You want to determine how the 10-year-rule fits into your own planning, so you don’t bump your income too high and miss out on tax benefits that have income limitations (certain tax credits, ability to contribute to a Roth IRA, push you into additional Medicare tax, etc.). In other words, once you receive the inherited money you need to answer, “what’s the most advantageous way for me to receive this money over a ten-year time frame?”

That’s a lot to think about during a stressful phase of life. Remember, we’re here to guide you!

Note: this information is specifically addressing beneficiaries who are inheriting parental pre-tax 401(k) accounts after January 1, 2020. The type of beneficiary drives what specific rules and distribution period are required. So, it’s best to consult with a financial advisor or tax adviser if your situation is different than what’s listed above.

 

Liz Gillette
Liz Gillette
liz@mainstreetplanning.com

Liz has tackled her own path to financial freedom, paying off student loan debt & medical bills, and consequently acquired a passion for empowering other women and men to transform their fiscal lives. Her aspiration is to bring clarity and simplicity to personal finance while aligning clients’ unique personal values to their spending.

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