How to Manage Complicated Rules for a Legacy 401 (k) or IRA

So you inherited a retirement account.

Before making decisions about when and how to access the money, it is worth familiarizing yourself with the rules that apply to the different beneficiaries. The rules for these retirement plans can be tricky. Therefore, mistakes can be made and, depending on the details, can be difficult to undo.

Because of the Safe Law of 2019, your options for managing a 401 (k) hereditary plan or an individual retirement account now depend largely on your relationship with the person who died. This legislation eliminated the ability of many beneficiaries to extend distributions throughout their lives if the original account owner died on or after January 1, 2020.

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Unless you comply with an exception (for example, you are the spouse or minor child of the deceased), these inherited accounts generally must now be exhausted within ten years.

This is what you need to know.

If the beneficiary is the minor of the deceased person, the 10-year exhaustion rule begins when they reach the age of majority where they live. In most states, he is 18 years old.

Before reaching this point, however, the child should take required minimum annual distributions, or RMDs as they are known, according to their own life expectancy. (Mandatory withdrawals usually start for retirement savers at age 72 or 70 ½ if they arrive before 2020 according to the expected useful life of the account owner).

“So if you have a 10-year-old child taking RMD, they would do it until they were 18 when they would move on to the 10-year rule,” said Brian Ellenbecker, a certified financial planner at Shakespeare Wealth Management in Pewaukee, Wisconsin.

In addition, a beneficiary who is ill or chronically disabled or who is not more than ten years younger than the deceased may make distributions according to his or her own life expectancy and is not subject to the ten-year rule.

If you are a beneficiary subject to the ten-year exhaustion rule because you do not meet an exception, it is important to consider how you will meet this requirement.

“There’s no fixed amount that has to be taken every year, but everything has to be withdrawn in ten years,” said PP Peggy Sherman, senior advisor to Briaud Financial Advisors in College Station, Texas.

The process basically involves setting up an inherited IRA and transferring the money to it. This is the case if the original account is an IRA or 401 (k).

There are a couple of different things to keep in mind in this situation, including whether the legacy account is a traditional version or Roth.

Distributions of Roth accounts are usually tax-free, while traditional ones are taxed upon withdrawal. (Please note that if you inherited a Roth account opened less than five years ago, the profits withdrawn would be taxable, while the amounts contributed after taxes would still be tax-free.)

So if it’s a Roth and you don’t pay taxes for distributions regardless of when you make them in that ten-year period, it might be worth leaving the money in it until the 10th year so that it can continue to grow tax-free, said Sherman.

On the other hand, if it is a traditional IRA or 401 (k), it is worth evaluating the tax aspect of taking distributions. Since money would be taxed as ordinary income, taking many at a time could clash with a much higher tax bracket. The distribution of distributions over the decade could minimize the tax impact in a given year.

If you do not empty your account within ten years, the remaining assets in your account could be subject to a 50% penalty.

Meanwhile, heirs sometimes end up having a retirement account through an estate; that is, they were not the beneficiaries listed, but they end up with the account when the farm goes through the test and the assets are distributed.

In this case, different rules apply. The account should generally be exhausted within five years if the original account owner had not started taking RMD, according to Vanguard. If the RMDs were in place, the heir would essentially have to maintain these withdrawals.

Spouses have more options when they inherit a retirement account.

The first is to take the money to your own IRA. In this case, you should follow the standard RMD rules, that is, when you reach the age of 72, start making the necessary withdrawals based on your own life expectancy.

“If the surviving spouse doesn’t need the income, it will probably end up being the best option because it can give them time for the money to continue to grow in the account,” said Ellenbecker of Shakespeare Wealth Management.

However, he said, this also means you will be subject to an early withdrawal penalty of 10% if you are under 59 and withdraw money from that account.

The way to avoid this is to place the money in an inherited IRA and continue to be the beneficiary. In this case, the penalty will not apply to you. Also, RMDs, which would be based on your life expectancy, should not start until the deceased spouse has reached the age of 72, Ellenbecker said.