Retirement accounts are designed to provide a way for individuals to invest, and after they stop working, access those funds to cover their expenses. Accounts can be employer-sponsored, as in the case of a 401(k) plan, or they can be Individual Retirement Accounts (IRAs). Retirement accounts are regulated by numerous Internal Revenue Service (IRS) rules, which provide parameters for maximum yearly contributions, penalties for early withdrawals, and mandatory distribution amounts based upon the age and life expectancy of the account holder.
Retirement Accounts After Death
When the owner of a retirement account dies, the account can be given to a beneficiary. A beneficiary can be any person or entity that the owner has chosen to receive the funds. If no beneficiary is designated beforehand, the estate will generally become the recipient of the account.
There are many factors that determine what a beneficiary of a retirement account can do with the account, as well as the tax consequences. The IRS’ expansive rules and options are based on the type of IRA (traditional or Roth), whether or not a beneficiary was designated, whether the account holder died before or after the beginning date of “required minimum distributions” (RMDs), and whether the account’s sole beneficiary is a surviving spouse or widow.
Surviving Spouse is Sole Beneficiary
A surviving spouse who is the sole beneficiary has multiple options when deciding what to do with the account.
- Treat the IRA As Their Own – According to IRS rules, he or she can treat the IRA as his or her own. The standard rules applying to the account would then apply to the surviving spouse. The spouse will then be able to name new beneficiaries and make contributions and withdrawals. Withdrawals are subject to a 10 percent federal income tax penalty if the spouse has not reached age 59 ½, (required minimum distributions begin at age 70 ½.) It is important to note that when any funds are withdrawn or distributed from the account, all nondeductible amounts will be taxable as gross income. Further, if required minimum distributions are not taken according to IRS rules, a 50 percent excise tax is levied on the amount that was not withdrawn but should have been. (This penalty applies to all beneficiaries.)
- Roll The Account Over Into His Or Her Own Retirement Account – Some retirement plans require that a deceased employee’s account be distributed in a lump sum. To avoid an immediate tax obligation, a surviving spouse can choose to roll over the account into his or her own IRA or other retirement plans. A surviving spouse choosing this option has 60 days after the death to roll over the money and required minimum distributions will begin when the surviving spouse turns 70 ½.
- Continue As The Beneficiary – This option can be considered if an individual dies before the age of 70 ½ and the surviving spouse has not yet reached 59 ½. By continuing as the beneficiary, required distributions will be delayed until the point at which the deceased individual would have had to make them. The surviving spouse will then be able to withdraw funds without incurring the 10 percent early withdrawal penalty. Once the surviving spouse reaches age 59 ½, the account could be rolled over.
- The 5-Year Rule Option – If the spouse died before age 70 ½, the surviving spouse can also choose the 5-Year Rule option. This option requires the surviving spouse to withdraw all the funds by December 31 of the fifth year following the death.
There are different options and restrictions when a non-spouse is the beneficiary of a retirement account. The options available for non-spouse beneficiaries include:
- Cash-out the account and pay taxes on the distribution.
- The 5-Year Rule Option
- Treat The Account As An Inherited IRA – this option requires minimum distributions be taken by December 31 of the year following the account owner’s death.