Inherited an IRA or 401(k)?

Inherited an IRA or 401(k)?  There may be tax consequences!

People come to me as if I am operating a confessional.   I don't know what it is, but for some reason, they like to unload on me.  And recently, I heard a story that at first, took me by surprise, but after I thought about it, it made sense.

Susan, who works as a nurse, was listed as beneficiary on her Father's IRA plan.   He died unexpectedly, and when she went to settle the Estate, her tax adviser told her that there would be both Federal and State taxes due on the IRA plan - that she would have to pay.

Huh?  This is something new!

You see, from a Federal standpoint, you generally do not pay taxes on an inheritance.   It is the biggest tax-free giveaway there is.   If Mom and Dad leave you a Million Dollars, then you get it, free and clear, with no Federal Taxes to pay.   You might have to pay State taxes (consult your local tax adviser) but no Federal Taxes.

Oh, but what about the "Death Tax" that the odious Glenn Beck rails about?    It is paid by the Estate - not you - and then only on amounts higher than the exemption, which until recently was about $5 Million dollars (again, consult your tax adviser for the latest exemption amounts - for one brief year, there was no Estate tax at all!).

But an IRA or 401(k) or other tax-deferred plan is a different beast, isn't it?   Taxes were never paid on that money.  The way the scheme was supposed to work, the person who owned the Plan would pay taxes on the money, as they withdrew it in retirement.  But if that person dies before they withdraw the money, then what?   No one paid taxes on that money - and Uncle Sam isn't going to let that go unnoticed.

So the money is taxable, unlike, say, just plain cash you inherit.   And how you pay those taxes can affect how much you pay.   And the rules for IRAs and 401(k)s are slightly different, as well.  It is not as simple as it might first appear.

If you are a spouse, the rules for an IRA are pretty lenient - you can roll over the IRA into your own, and then defer paying taxes on it until you decide to withdraw from the account.   But you still have to pay taxes on it, of course, when you withdraw the money from the plan.

If you decide to cash it in, however, it is considered ordinary income.   And if you are cashing in a $250,000 account, that will likely push you in to a much higher income bracket, and you will be expected to pay State and Federal taxes on this.   And to prevent unpleasant surprises on April 15th, you need to mail in some estimated tax payments ahead of time.

If you are not a spouse, the options are more limited, but again taxes must be paid on the money - eventually.  Again, you can cash it out, but this may knock you into a higher bracket, which will result in the highest tax burden to you.   If the person who left you the money had not started withdrawing the money yet (reached age 59-1/2 or the mandatory year of 70-1/2) then you can spread out the payments over five years - which may keep you in a lower tax bracket.

If the person leaving you the money had started to draw down the money, then you can withdraw at the same pace, and thus take out less money over time, and hopefully not end up in a higher tax bracket.

Of course, it goes without saying that if you are young and still contributing to your IRA or 401(k), you can use this money to do so, and offset your income up to the limits allowed, and possibly negate any tax consequences at all.

For a 401(k) plan, you may be able to stretch out the distribution and avoid a large lump-sum payout, in a similar manner to how an IRA is handled for non-spouses.   There does not seem to be any distinction between spouse and non-spouse for a 401(k).   However, the rules of the plan may dictate how this is handled, so you need to consult a tax adviser on this.   You can, of course, cash out the plan and pay all the taxes at once, although this is not an optimal outcome.

Unfortunately, Susan decided to cash out the plan, and use the money to buy things for herself.   This was a bad idea on several grounds.   First of all, this was her inheritance, and she should have taken this lump-sum payout and used it to fund her own IRA, rather than spend it on a car or trips to Chi-Chi's.   Now the money is gone, and as Susan says, "I have so many bills to pay!"

Second, by cashing it out, it knocked her into a higher tax bracket, at both the State and Federal levels, so instead of paying at the 15% level, she is now paying a 25% marginal rate.   If she had remained beneficiary of the account and taken small amounts over time, it would not have taxed her as much.

The third problem is that she failed to pay enough money to the IRS when cashing out the plan, and thus when April 15th rolled around, she had under-paid her taxes.   She waited until October to file her return, as which point she was horrified to discover she owed an additional $800 plus late fees and interest on her taxes.

While $800 is not a lot of money to most people, since she was so heavily in debt, she didn't have the cash to pay it off.   She had to work out a payment plan with the IRS.

Compounding the problem was the tax preparer she used, who insisted on being go-between between her and the agency - and waited six months before working out the payment plan, incurring more interest and penalties.  And it was one of those big-name chain tax return places, too (big surprise there!).

I felt bad for this lady, to some extent, because she was making some bad life choices.   As a professional, she had a steady income, and assure career, and made decent, if not spectacular money.   In fact, she probably makes more than I do!    But she has wallowed in debt, and worries all the time about paying her creditors, and of course, was scared to death of the IRS over an $800 tax delinquency, which she had a hard time paying (!).

She wanted to sue her tax preparer - sue someone - over this.   But I think she was missing the bigger picture - that cashing in your inheritance and spending it - and then going further into debt, was no answer to her problems.   And in fact, her desire to acquire debt (and it is a desire, not a "need") was the largest problem in her life - and a largely self-inflicted problem at that.

* * *

For more information on the Rules for handling an inherited 401(k), see Publication 575 of the IRS  The rules are similar to that with an IRA, but may be plan-specific, so you need to consult a tax adviser for more information.

For more information on the Rules for handling an inherited IRA, see Publication 590 of the IRS:

What if You Inherit an IRA?

If you inherit a traditional IRA, you are called a beneficiary. A beneficiary can be any person or entity the owner chooses to receive the benefits of the IRA after he or she dies. Beneficiaries of a traditional IRA must include in their gross income any taxable distributions they receive.

Inherited from spouse.   If you inherit a traditional IRA from your spouse, you generally have the following three choices. You can:

1. Treat it as your own IRA by designating yourself as the account owner.
   
2. Treat it as your own by rolling it over into your IRA, or to the extent it is taxable, into a:
   
   1. Qualified employer plan,
      
   2. Qualified employee annuity plan (section 403(a) plan),
      
   3. Tax-sheltered annuity plan (section 403(b) plan),
      
   4. Deferred compensation plan of a state or local government (section 457 plan), or
      
3. Treat yourself as the beneficiary rather than treating the IRA as your own.
   

Treating it as your own.   You will be considered to have chosen to treat the IRA as your own if:

• Contributions (including rollover contributions) are made to the inherited IRA, or
  
• You do not take the required minimum distribution for a year as a beneficiary of the IRA.
  

You will only be considered to have chosen to treat the IRA as your own if:

• You are the sole beneficiary of the IRA, and
  
• You have an unlimited right to withdraw amounts from it.
  

However, if you receive a distribution from your deceased spouse's IRA, you can roll that distribution over into your own IRA within the 60-day time limit, as long as the distribution is not a required distribution, even if you are not the sole beneficiary of your deceased spouse's IRA. For more information, see When Must You Withdraw Assets? (Required Minimum Distributions) , later. 

Inherited from someone other than spouse.   If you inherit a traditional IRA from anyone other than your deceased spouse, you cannot treat the inherited IRA as your own. This means that you cannot make any contributions to the IRA. It also means you cannot roll over any amounts into or out of the inherited IRA. However, you can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary.   Like the original owner, you generally will not owe tax on the assets in the IRA until you receive distributions from it. You must begin receiving distributions from the IRA under the rules for distributions that apply to beneficiaries. 

IRA with basis.   If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. Unless you are the decedent's spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own traditional IRA(s) or any basis in traditional IRA(s) you inherited from other decedents. If you take distributions from both an inherited IRA and your IRA, and each has basis, you must complete separate Forms 8606 to determine the taxable and nontaxable portions of those distributions. 

Federal estate tax deduction.   A beneficiary may be able to claim a deduction for estate tax resulting from certain distributions from a traditional IRA. The beneficiary can deduct the estate tax paid on any part of a distribution that is income in respect of a decedent. He or she can take the deduction for the tax year the income is reported. For information on claiming this deduction, see Estate Tax Deduction under Other Tax Information in Publication 559, Survivors, Executors, and Administrators.   Any taxable part of a distribution that is not income in respect of a decedent is a payment the beneficiary must include in income. However, the beneficiary cannot take any estate tax deduction for this part.   A surviving spouse can roll over the distribution to another traditional IRA and avoid including it in income for the year received.