The taxation of your retirement accounts is always a big concern. Last week we looked at how those assets are taxed while you are living. Today is part 2. We look at the tax implications of those 401k and IRA Accounts when you die.
Taxes in Retirement Series
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In Part 1, we met Bill and Janet. (you can see the details of their situation, here). They have a daughter, Barbie who is married to Ken. They live in Malibu, California. Bill and Janet are wondering how their 401(k) and IRA accounts will be taxed when they die.
How are Retirement Accounts Taxed when One Spouse Dies?
As long as the surviving spouse is named as the primary beneficiary, there are no taxes due on traditional IRAs or pre-tax 401k's when the first spouse dies. The surviving spouse moves it into his or her own IRA and treats it as if it is their own. There are exceptions to this and that is discussed below. In Bill and Janet's case, this is what we see.
For the purpose of this illustration, Bill dies at age 71. The value of his account at his death is $233,085.
Janet is the sole primary beneficiary. Bill's balance transfers directly to Janet, and she puts it in her IRA. At age 75, in this specific case, Janet will have to begin taking required minimum distributions from her now combined account.
There are no immediate tax liabilities due to her from this transfer.
The Unusual Exceptions
There are two uncommon exceptions to the surviving spouse treating their spouse's IRA as their own. The first is if the surviving spouse is younger than age 59 1/2. In this instance the surviving spouse would want to move their balance to an inherited IRA. This would give them access to the funds without the 10% IRS penalty.
The second exception is when the surviving spouse is significantly older than the deceased spouse. In this case, the surviving spouse would also want to use an inherited IRA. They can use the deceased spouse's age for required minimum distributions going forward.
How are retirement accounts taxed when a spouse isn't the beneficiary?
In Bill and Janet's case, they have one child, Barbie. After Bill died, Janet changed the beneficiary of her IRA account to Barbie. Because Janet's IRA was funded with pre-tax dollars (meaning there was a tax deduction taken for the contributions to the accounts), Barbie gets an interesting tax bill.
For purposes of illustration, Barbie and her Husband Ken have a combined State and Federal income tax rate of 30%. When Janet died at age 82, her IRA account is worth $487,427.
Barbie and Ken will be facing an income tax liability of nearly $137,000 on the inherited IRA.
The tax bill isn't immediate...
IRS rules require non-spouse individuals to completely liquidate their inherited IRA within 10 years (if the deceased account owner died after 2019). Whether they have an annual distribution requirement or not depends on other factors. In this specific case, Barbie and Ken will have a requirement to take annual distributions based on Barbie's remaining life expectancy. This means Barbie has to take a minimum amount in each of the first nine years based on her age. Those distributions will start the year after her mother passed away.
The account must be liquidated by the end of the 10th year after she started taking distributions. If she only takes the minimum in years one through nine, that last distribution could be quite large depending on the investment results.
There are some exceptions to this, but they are less common.
What about non-human beneficiaries?
If a person is not named as your beneficiary, you could face a tax bill much sooner. The rules require the account to be distributed by the end of the fifth year. There are some exceptions to this rule as well.
The hidden tax torpedo?
There have been many mainstream media articles about the pitfalls of traditional 401k and IRA accounts. The biggest reason is the taxes that will eventually be paid by others. For most people nearing retirement, the pre-tax contributions were the only option they had—Roth 401k accounts weren't introduced until 2006. You have to work with what you have.
In most cases, Roth accounts are a better tool to use when saving for retirement, if they are available. However, you must remember the effort you put into saving is going to be one of—if not the most important—factor in your success. Employer-sponsored plans, like the 401k, make it easy to save. If you are using pre-tax contributions because it is the easiest and only option you have, then keep on saving.
Just remember, at some point, taxes will be due.
The multi-generational tax decision
We all have a partner in our financial lives. Both the federal and (most) state governments will share in your retirement savings. It is not uncommon to hear clients question the value of whether they should pay the taxes on their kids' inheritance. In part 3 of this series, we are going to illustrate the potential value of Roth conversions. But the mindset needs to shift from who pays the taxes to lowering the overall tax bill over time. If you want to make sure you see that episode, fill out the form below.
In this video...
Vince is a financial advisor in Parkersburg, West Virginia
Neal Watson, CFP®
Neal is a financial planner in Marietta, Ohio.