Income Tax Consequences of Inheriting an IRA or 401(k) if You're Not a Surviving Spouse
If you're not the surviving spouse of the IRA or 401(k) account owner, then the income tax consequences of inheriting the account will depend on what you choose to do with it:
- Transfer the account into an inherited IRA - If you elect to transfer the account into an inherited IRA, then you'll be required to begin taking minimum distributions by December 31 of the year following the deceased owner's death and the distributions will be calculated over your own life expectancy. You can also take out additional amounts as needed. Each time a distribution is taken, be it required or not, the amount of the distribution will be included in your taxable income. But be aware that currently for some 401(k)s, transferring the account into an inherited IRA is not an option due to the policies of the company maintaining the plan. However, the Worker, Retiree and Employer Recovery Act of 2008 (or WRERA) requires all employers to offer this option by January 1, 2010.
- Cash out the account in full - If you choose this option, then 100% of your distribution will be included in your taxable income.
Estate Tax Consequences of Inheriting an IRA or 401(k) if You're Not a Surviving Spouse
The entire fair market value of the IRA or 401(k) will be included in the value of the deceased owner's estate for estate tax purposes. Thus, if all of the deceased owner's other assets combined with the value of the IRA or 401(k) exceed the current federal or state estate tax exemption, then the deceased owner's estate will owe estate taxes.
What Happens if the IRA or 401(k) is Needed to Pay Estate Taxes?
If the deceased owner's estate is taxable but there isn't enough assets outside of the IRA or 401(k) to pay the estate tax bill, then this will pose a serious problem for the beneficiary of the IRA or 401(k). Why? Because each and every withdrawal from an IRA or 401(k) will result in the amount withdrawn being included in the beneficiary's taxable income. And what if the beneficiary needs to take additional cash out of the account to pay their increased income tax bill? This will result in additional income taxes on the amount withdrawn. The final result can be financially devastating to your loved ones - from 50% to nearly 90% of the retirement account being lost to estate and income taxes. The only way to avoid this is to insure that your estate has enough cash or other liquid assets outside of the retirement account to pay the estate tax bill.