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Inheritance and retirement savings accounts guide

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Retirement savings accounts are designed to give people tax incentives to save for their future needs. So what happens when those savings extend beyond the individual's lifetime, and pass to the next generation?

If you have an Individual Retirement Account (IRA), 401(k) or Health Savings Account (HSA), your estate planning should include not only designating who would benefit from those accounts after you pass away, but also understanding the tax impact of leaving money to your heirs in this way.

On the other side of the coin, if you expect to inherit money from a retirement savings account, you should also understand the tax implications so you know what to expect and have a plan to identify and access the accounts left to you.

It should be emphasized tax implications can depend very much on individual circumstances, so you should consult with an estate planning attorney or a tax expert before making any final decisions. However, knowing the general rules will help you start to understand your options.

General rules for inheriting retirement savings accounts

First, it is helpful to know the general tax treatment for inherited retirement savings accounts. The market value of those accounts will be included in the value of the estate for the purposes of determining estate taxes, which may be due if the total value of that estate is greater than $5,490,000 (this is the applicable figure for 2017; note that this number is subject to change over time due to inflation adjustments and changes in tax laws).

In addition to estate taxes, there may be individual income tax implications for the person inheriting the account. Here is how that might impact different types of retirement savings accounts:

Inheriting an IRA

First, there is a crucial distinction between what happens when a spouse inherits an IRA and when the IRA is left to a beneficiary other than the spouse.

The spouse has the option of treating the IRA as his or her own from that day forward, or for following the general rules for beneficiaries. Beneficiaries who do not want the immediate tax hit of receiving all the proceeds from the IRA at once can carry the IRA forward in the deceased person's name. Then they receive money out of it gradually over time.

There will be required minimum distributions annually, based either on the life expectancy of the beneficiary, or the life expectancy of the deceased immediately prior to death. Income taxes will be due upon distributions.

For a Roth IRA, the beneficiary's interest in the account usually must be distributed within five years of inheritance.

Inheriting a 401(k)

The rules for inheriting a 401(k) plan balance are generally the same as those for inheriting a traditional IRA. Spouses can roll the balance over into an IRA in their own name and treat as their own account, or transfer it into an IRA in the name of the deceased and follow the applicable required minimum distribution rules.

Beneficiaries other than the spouse must maintain the account balance in an IRA in the deceased's name and take the applicable minimum distributions.

Inheriting an HSA

Besides their use for meeting immediate out-of-pocket health care expenses, HSA balances can be carried forward and accumulated tax free. Americans are increasingly taking advantage of this to build savings that can be used for health care costs in retirement.

When an HSA balance remains upon death, inheriting spouses can treat the account as their own HSA, with balances growing tax-free and with no tax on distributions as long as they are used for qualified medical expenses. However, if the beneficiary is someone other than a spouse, the account ceases to be considered an HSA and the proceeds are taxable to the beneficiary in the year of the original account holder's death.

How to prepare your retirement accounts for heirs

  • Name beneficiaries for accounts in will. If you have retirement savings accounts, be sure you have clearly designated the beneficiaries for each with the plan administrator, and you should also have this information reflected in your will.
  • List your retirement accounts and their locations. It can help to keep a list of your accounts in a secure location, and make sure your executor knows where to find it.
  • Meet with an estate planning attorney. You might also wish to talk to an estate planning attorney about alternatives for reducing the inheritance tax impact, such as putting some of your money in trusts on behalf of the eventual beneficiaries, or taking advantage of regular gifting within the annual tax-free maximum. However, these maneuvers are likely to entail taking distributions out of retirement savings accounts, which is likely to have tax consequences for you.

What to do if you may inherit a retirement savings account

If you are expecting to inherit money from a retirement savings account, consider these steps:

  1. Know what kind of a tax hit to expect. When you find out the amount of a retirement plan balance that has been left to you, don't make plans based on the full amount. Understand the tax implications so you will know what amount of money you will actually be dealing with by the time it is distributed to you, and also consider whether it might be best to take distributions over time rather than all at once.
  2. Be flexible in including it in your plans. If someone has mentioned an amount they plan on leaving you in a retirement account, keep in mind that market values can vary. Also, that person may end up having to draw on the account more heavily than planned for their own needs.
  3. Research your options in advance. If you know what type of account you will inherit, find out in advance what your options are and how they affect the tax treatment. Often there is a limited time to make rollover decisions to defer taxation, so it helps to have a head start on the research.
  4. Know the name and number of the estate attorney. If you expect to inherit, know who to contact to confirm what the final details were.
  5. Ask the executor to see the final account statement. As the estate process starts, you should ask the executor of the will for a copy of the final account statement for any retirement savings plan that will be passing to you. This will allow you to begin to make plans, and will help ensure that you get everything that is supposed to be coming to you.

Inheriting money is often a bittersweet experience, but the best way to honor the legacy of the person who left you that money is to make responsible decisions about how to handle your inheritance.

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