Retirement savings account owners and their loved ones should understand these complicated rules. Depending on a number of different factors, inheriting retirement plan assets could have a significant impact on a beneficiary’s tax obligation.
FIRST, A BIT ABOUT REQUIRED MINIMUM DISTRIBUTIONS:
The rules governing retirement plans are designed to ensure that accounts don’t benefit from taxdeferred growth indefinitely. For that reason, account owners generally must begin taking required minimum distributions (RMDs) from traditional pre-tax accounts by April 1 of the year following the year they reach age 73. This is known as the required beginning date, or RBD.
Different rules apply to beneficiaries. The timing and amount of RMDs on inherited accounts depend on whether the beneficiary is:
- a spouse who is the sole
beneficiary - another eligible designated
beneficiary (EDB) - an individual who is not an EDB
- not an individual (e.g., an estate
or charity) - The RMD rules also depend on
whether the owner dies before or on or after the RBD.
SPOUSE AS SOLE BENEFICIARY:
Spouses who are sole beneficiaries receive preferential treatment. By default, a surviving spouse beneficiary is treated as an EDB, with certain advantages.
If the account owner dies before the RBD: the spouse may elect to be treated as the deceased spouse for RMD purposes, waiting until December 31 of the year in which the deceased would have reached the RBD and calculating distribution amounts using the Uniform Lifetime Table rather than the Single Life Expectancy Table, if this is favorable.
If the account owner dies on or after the RBD: the spouse may take RMDs according to the longer of their own life expectancy or the deceased spouse’s.
Alternatively, regardless of when the account owner died, a spouse can roll over account assets to their own IRA or retirement plan account (if permitted), make additional contributions, name their own beneficiaries, and base distributions on their own RBD and life expectancy. However, distributions prior to age 59½ may be subject to an early withdrawal penalty, unless an exception applies.
ELIGIBLE DESIGNATED BENEFICIARIES:
EDBs have certain advantages over other beneficiaries. EDBs are spouses and minor children of the account owner, beneficiaries who are not more than 10 years younger than the account owner (such as a closen-age sibling), and those who meet the IRS’s definition of disabled or chronically ill.
If the account owner dies before the RBD: the beneficiary may use their own life expectancy to determine the RMDs.
If the account owner dies on or after the RBD: an EDB may calculate distributions using their life expectancy or the remaining life expectancy of the account owner, whichever is more beneficial.
Once a minor child reaches age 21 or after an EDB dies, the account must be distributed within 10 years.
OTHER DESIGNATED BENEFICIARIES:
Designated beneficiaries who are not EDBs are required to liquidate inherited accounts by December 31 of the year of the 10th anniversary of the account owner’s death. This could result in an unanticipated and potentially large tax obligation.
If the account owner dies before the RBD: the beneficiary is not required to take annual RMDs but must still liquidate the account by the end of year 10. In this case, the beneficiary might want to spread the distributions over the 10 years in order to manage the annual tax liability. By contrast, the beneficiary of a Roth account — which generally provides tax-free distributions — might want to leave the assets intact for the full period, allowing the account to potentially benefit from tax-free growth for as long as possible.
If the account owner dies on or after the RBD: the beneficiary is generally required to take RMDs based on their own life expectancy in years one through nine and then liquidate the remaining assets in year 10. Because the IRS had not issued final regulations for the new rules until mid-2024, it has issued notices stating that certain beneficiaries who did not adhere to the annual RMD requirements under the 10-year rule for 2021, 2022, 2023, and 2024 won’t be subject to any penalties.
ADDITIONAL CONSIDERATIONS:
Beneficiaries may withdraw more than the required amount each year, but not less.
A beneficiary may also disclaim an inherited retirement account. This may be appropriate if the initial beneficiary does not need the funds and/or want the tax liability. In this case, the assets may pass to a contingent beneficiary who has greater financial need or may be in a lower tax bracket or to the decedent’s estate. A qualified disclaimer statement must be completed within nine months of the date of the account owner’s death.
If the original account owner was of RMD age and failed to take the required amount in the year of death, the beneficiary must take the account owner’s distribution by December 31 of that year. In subsequent years, the beneficiary can use their life expectancy (only through year nine, in the case of a designated beneficiary who is not an EDB).
OTHER BENEFICIARIES (NON-INDIVIDUAL):
For beneficiaries that are not individuals, such as a charity or the decedent’s estate:
If the account owner dies before the RBD: The account will need to be liquidated by December 31 in the year of the 5th anniversary of the account owner’s death (no annual RMDs are required).
If the account owner dies on or after the RBD: Annual RMDs must be taken using the account owner’s remaining life expectancy.
If the beneficiary is a trust, the rules are even more complicated and beyond the scope of this article. Individuals should seek the assistance of an estate-planning attorney.
MISTAKES CAN BE COSTLY:
Individuals should take special care to understand the rules regarding the inheritance of retirement plan assets. Failure to take the appropriate amount in any given year can result in a penalty equal to 25% of the difference between the amount that should have been withdrawn and the actual amount received. (The penalty may be reduced to 10% if the error is corrected in a timely manner.)
Retirement account owners should review their beneficiary designations with their financial or tax professional and consider how the rules may affect inheritances and taxes. Any strategies that include trusts as beneficiaries should be considered especially carefully.