by Inheriting an IRA or 401(k) can add to your wealth, but it can also bring potential tax problems. A tricky problem concerns the required minimum distributions or RMDs. Owners of IRA and 401(k) plans are required to take minimum distributions from their accounts starting the year they turn 72. The IRS has special rules regarding the RMD in the year of death that IRA and 401(k) beneficiaries should be aware of.
A financial advisor can help you plan your retirement to put your mind at ease.
When do RMDs start?
The tax law requires certain retirement account owners to begin taking minimum distributions once they turn 72. The types of accounts subject to RMDs include:
Roth IRAs are not subject to RMDs during the life of the account owner. However, you are subject to RMDs if you inherit a Roth IRA. The IRS is very specific about when these distributions should begin. The required start date (RBD) for RMDs is April 1st of the year following the year in which the account holder turns 72. That is important to understand when an RMD is needed in the year of death.
When is an RMD in the year of death required?
If you inherit an IRA or other tax-advantaged account subject to RMDs, the timing determines whether you should take an RMD in the year of death.
This is how it works:
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You must take an RMD if the account owner has reached the required start date but has not made a required minimum distribution for the year.
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You don’t need to take an RMD if the account owner dies before the required start date.
Here’s an example of how this works. Suppose your father turned 72 in March 2020, making his required start date April 1, 2021. He will pass away in November 2021 without taking his RMD for that year. In that case, you would be responsible for taking the distribution as a beneficiary of the account.
Now suppose your father passed away in March 2021 instead. Since he has not yet reached his required start date, you are not required to take an RMD in the year of death.
When beneficiaries are required to take an RMD in the year the account holder dies, the amount will be reported as income on their tax returns. They have to pay taxes on it, in the same way that the owner of the account would have done if he had made the distribution himself.
How to Calculate RMD in Year of Death
If you need to withdraw RMDs in the year of death after the account owner has passed away, the calculation method is based on the RMD they would have received. Under IRS rules, the RMD for each year is determined using this formula:
Required minimum distribution = account balance at the end of the previous calendar year divided by a distribution period from the IRS Uniform Lifetime Table
The Uniform Lifetime Table is designed for unmarried IRA owners, married IRA owners whose spouses are no more than 10 years their junior, and married owners whose spouses are not the sole beneficiaries of their IRAs. Table I (Single Life Expectancy) is used when the beneficiary is not the spouse of the IRA owner. Table II (Joint Life and Last Survivor Expectancy) is used for owners whose spouses are more than 10 years younger and the sole beneficiary of the IRA.
If the account owner has named multiple payees and has not taken their required minimum distribution, each payee will share responsibility for it. Beneficiaries can split the account into multiple inherited IRAs, allowing them to claim their share of the account balance while carrying their share of the tax liability.
For RMDs in the year following the death of the account holder, the distribution calculations will depend on who the beneficiary of the account is. In general, designated beneficiaries will use the IRS Single Life Expectancy Table to calculate distributions. This table uses life expectancy and IRA balance to determine RMDs.
What if you don’t take RMD in the year of death?
The deadline for taking RMDs in the year of death is December 31st of the year in which the original account holder dies. The IRS imposes a strict penalty when RMDs are required but not taken by beneficiaries. If you inherit an IRA or 401(k) and don’t take the RMD before the year of the account owner’s death, a 50% tax penalty will apply.
There is an exception if the estate is named as the beneficiary of an IRA. The estate then takes the RMD and is responsible for declaring the division.
The 50% penalty can significantly reduce what you can withdraw from an inherited IRA or 401(k). For that reason, it’s important to understand when RMDs are or aren’t required when the account owner passes away. Talking to a tax professional or your financial advisor can help you prepare for any tax liabilities that may arise if you inherit an IRA or 401(k) from someone else.
Withdraw an inherited IRA
The IRS rule for year of death RMDs isn’t the only tax rule you should be aware of with inherited retirement accounts. You should also be aware of your tax liability for the management of the account in future years.
Spouses have several options for inheriting an IRA. For example, they can:
If you are not the spouse of the account owner, you can only set up an inherited IRA. You can no longer make new contributions to the account. You must also withdraw all funds in the account in full. You have 10 years after the death of the original account owner to do so. If you fail to do so, the Tax and Customs Administration may impose a tax fine on you.
In terms of how withdrawals are taxed, they follow the same tax rules as the original IRA. So if you inherit a traditional IRA, withdrawals are taxed at your regular income tax rate. If you inherit a Roth IRA, RMDs are required, but withdrawals are tax-free as long as the account is at least five years old.
It comes down to
Taking over retirement accounts can worsen your tax situation, and it’s important to be aware of the rules for death year RMDs. The most important thing to know is when the required start date is from the account owner, as they can decide whether you need to take an RMD in the year of death or not.
Retirement planning tips
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Consider talking to your financial advisor about dealing with an inherited retirement account. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisor matches for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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When flipping an inherited IRA, think about which brokerage you want to use to hold those funds. Brokers can vary widely in the fees they charge and the range of investment options they offer. Comparing different online brokers can help you find the best place to keep inherited retirement funds.
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