Maximizing Tax Benefits When You Inherit a Retirement Account

Even if you’re a long way from retirement yourself, you may inherit an IRA or other retirement account from a relative who passes away. Understanding the tax rules and withdrawal options can help you keep more money growing tax-deferred in the account for years – and can even help you jumpstart your own retirement savings.

If you withdraw the money from an inherited retirement account, you may not have to pay a 10 percent early-withdrawal penalty even if you’re under age 59½, but you could have a big tax bill — you’ll usually have to pay taxes on the full withdrawal, unless the owner made any non-deductible contributions. But there are ways to keep the money growing in the account tax-deferred for the future. The options depend on your relationship to the original account owner and the age when the owner died.

If the original IRA owner was not your spouse and died before age 70½, then you must either withdraw all of the money from the inherited IRA within five years or take required withdrawals every year starting by Dec. 31 of the year after you inherit the account, based on the IRS’s life expectancy factor for your age. (See IRS Publication 590-B at www.irs.gov for the calculation.) You can keep the rest of the money growing in the account tax-deferred for the future.

Spouses who inherit an IRA have an additional option — they can roll the money over into their own IRA. In that case, they won’t have to start taking traditional IRA withdrawals until they turn 70½, as they would with their own IRA, but they will have a 10 percent penalty for most withdrawals before age 59½.

If the original IRA owner was older than 70½ when he or she died, the beneficiary doesn’t have the option to spread out withdrawals over five years, but can still take annual withdrawals based on his or her own life expectancy or the deceased owner’s life expectancy, whichever is longer.

It’s also important to update the beneficiary designations on your own retirement-savings accounts — especially after you get married, divorced, or experience other life changes. The person you designated when you originally enrolled in your 401 or 457 plan, for example, may no longer be the person you’d like to inherit the account if several years have passed since then. The beneficiary designations supersede anything you’ve written in your will. It helps to give your beneficiaries a heads up about the tax rules for withdrawals, so they’ll be able to keep the money in the account and benefit from the tax deferral.

To check on your beneficiary designations, log in to Account Access, select the My Account tab, and the My Profile and Beneficiaries menu. If your plan permits online changes, you may be able to click the Update Beneficiaries button to make any changes to your beneficiaries or the percent of the account each beneficiary is to inherit.

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