The popularity of self-funded retirement accounts, such as a 401(k) or an individual retirement account (IRA), has increased dramatically over the last several decades as more and more companies do away with employer-sponsored retirement and pension plans. Given how common it now is for an IRA to be part of a retirement plan, inheriting an IRA has also become fairly common. If you recently learned that you are the beneficiary of an IRA, or you are contemplating the wisdom of including an IRA in your own estate plan, you need to know if an inherited IRA is taxable to the beneficiary.
When an Account Owner Dies, What Happens to an IRA?
When a participant in a retirement plan dies, benefits the participant would have been entitled to are usually paid to the participant’s designated beneficiary in a form provided by the terms of the plan, typically either in a lump-sum distribution or an annuity. Many retirement plans require the account owner to name a spouse as the beneficiary unless he/she signs a form allowing the owner to name someone else as the beneficiary. Moreover, the Employee Retirement Income Security Act (ERISA) protects surviving spouses of deceased participants who had earned a vested pension benefit before their death. The nature of the protection depends on the type of plan and whether the participant dies before or after payment of the pension benefit is scheduled to begin, otherwise known as the annuity starting date.
Assets held in a retirement account can be paid out to the beneficiary shortly after the owner’s death because retirement accounts are “non-probate” assets, meaning they bypass the probate process. Depending upon the type of plan, and whether the participant died before or after retirement payments had started, the plan administrator should provide the beneficiary with the following information after the beneficiary submits a certified death certificate:
- the amount and form of benefits (in other words, lump sum or installment payments under an annuity);
- whether death benefit payments from the plan may be rolled over into another retirement plan; and
- if a rollover is possible, the method and time period in which the rollover must be made.
Is an Inherited IRA Taxed?
If you inherit a traditional IRA from your spouse, you generally have the following three choices:
- Treat it as your own IRA by designating yourself as the account owner.
- Treat it as your own by rolling it over into a traditional IRA, or to the extent it is taxable, into a:
- Qualified employer plan
- Qualified employee annuity plan (section 403(a) plan)
- Tax-sheltered annuity plan (section 403(b) plan)
- Deferred compensation plan of a state or local government (section 457(b) plan), or
- Treat yourself as the beneficiary rather than treating the IRA as your own.
If you inherit an IRA from someone other than your spouse, you cannot treat it as your own. This means that you cannot make any contributions to the IRA or roll over any amounts into or out of the inherited IRA. Furthermore, a beneficiary of a traditional IRA will generally not owe tax on the assets in the IRA until the beneficiary receives distributions from it.
As a general rule, the entire interest in a Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner’s death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary. If paid as an annuity, the entire interest must be payable over a period not greater than the designated beneficiary’s life expectancy and distributions must begin before the end of the calendar year following the year of death. If the sole beneficiary is the spouse, he or she can either delay distributions until the decedent would have reached age 70½ or treat the Roth IRA as his or her own.
Please download our FREE estate planning checklist. If you have additional questions or concerns about IRAs, contact us at the Northern California Center for Estate Planning & Elder Law to find out today by calling (916)-437-3500 or by filling out our online contact form.