New Rules for Inherited IRAs and 401(k)s

3A spouse who inherits money from an IRA or 401(k) is not held to the new 10-year withdrawal rule. Instead, your options are:

Move the money into your own IRA.

You can roll the money into your own retirement account. No taxes are due when you move the money, and your required withdrawals will be based on your life expectancy. The general IRA rules for withdrawals apply. They are:

• For traditional IRAs: Any withdrawals made before you are 59½ incur a 10% early withdrawal penalty on top of regular income tax. You must begin to make required minimum distributions (RMDs) once you turn 73.
• For Roth IRAs: If you inherit a Roth 401(k), you can roll it into a Roth IRA without any tax due. Money that was contributed to the Roth 401(k) can be withdrawn at any time without owing income tax; earnings can be withdrawn without tax if the original account was at least five years old. 

Move the money into an Inherited IRA.

An Inherited IRA is a specific type of account available at financial institutions that also offer regular IRAs. Withdrawals made from an Inherited IRA are not subject to the 10% early withdrawal penalty typically charged if you take out money before reaching age 59½. If you inherit a retirement account before reaching 59½ and anticipate wanting to use the money sooner than later, the Inherited IRA account is a way to avoid the 10% early withdrawal penalty.

Keep the money in the 401(k).

If the plan rules allow you to do this, you will have to take RMDs based on the rules that applied to your spouse. There is no 10% early withdrawal penalty for money you take out before turning 59½.

The new rules for inheriting IRAs and 401(k)s typically require you to withdraw all the money within 10 years. There are a few exceptions where the old “stretch IRA” rules that base withdrawals on your life expectancy can still be used:

• A child under the age of 18 can use the stretch rules until they reach the age of 18, at which point the 10-year rule kicks in.
• You meet the IRS definition of being chronically ill or disabled. The rules are very specific; consulting a tax professional is wise.
• You are not more than 10 years younger than the account owner. For instance, if you inherit money from a big brother or sister who was only eight years older, you can time your withdrawals over your lifetime, based on the IRS Single Life Expectancy table.²

Money must be withdrawn within 10 years.

If you don’t meet any of the above exceptions, you must withdraw all the money by December 31 of the 10th year after the original account owner died.

Deposit location matters.

When you inherit money you don’t intend to use immediately, it must be deposited in an Inherited IRA account; you can’t put the money in an existing IRA account you might already have. There is no early withdrawal penalty for Inherited IRAs.

Income tax on withdrawals.

For tax purposes, money you withdraw from a traditional inherited IRA or 401(k) will be counted as ordinary income in the year you make the withdrawal. If you inherit a Roth 401(k) or Roth IRA, you must empty the account within 10 years, but all contributions the original owner made can be withdrawn tax free. If the account was at least five years old at the time the original owner died, your withdrawal of earnings will also be tax free.

For larger traditional accounts, spreading withdrawals over multiple years may help avoid tax-bracket creep: A big distribution from an inherited traditional IRA or 401(k) in a single year could bump you into a higher tax bracket. And if you live in a state that has income tax on retirement accounts, you’ll want to factor that into your tax calculations as well.

 
If you find yourself with lower earned income in a given year – and thus are likely in a lower tax bracket than usual – that may be a good time to take a larger distribution.

If you inherit retirement funds within 10 years of when you expect to retire (or semi-retire), it may make sense to wait until retirement to take your distribution, as most people have less income in retirement. But if you plan to enroll in Medicare when you become eligible at age 65, you also want to keep an eye on how a big withdrawal from an inherited retirement can raise your Medicare Part B and Medicare Part D premiums. For most Medicare enrollees, the monthly premiums are based on the income reported on your tax return from two years prior.

 
A huddle with a tax professional can be a smart way to devise a plan for when to withdraw the money within your 10-year window.