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What’s a Widow to Do With Inherited Retirement Accounts?

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Eve’s husband, Adam, has died, leaving various retirement accounts to her as beneficiary. She knows these are tax-sensitive assets and does not want to make a mistake. She seeks your advice: What should she do with these assets?

Here is a checklist of potential tax issues and elections Eve faces regarding the retirement accounts she has inherited from Adam.

For most surviving spouses in most situations, the best course of action is to “roll over” or transfer, to the surviving spouse’s own IRA, any account inherited from the deceased spouse, so we’ll review the steps for carrying out that process. But before getting to what “most” spouses do, let’s look at the exceptions: Does Eve have any of the following circumstances that might suggest not doing a spousal rollover of the inherited benefits, or at least not doing it yet?

Should Eve Disclaim?

Eve should first consider whether she wants this inheritance at all. Instead of accepting this inheritance, she can “disclaim” Adam’s retirement benefits, allowing them to pass directly to the contingent beneficiary. Disclaiming could make sense if, for example, Eve is a wealthy woman and does not want to increase the size of her own estate. If Adam did not take advantage of his own estate tax exemptions by leaving assets directly to their children or to a “bypass trust,” Eve’s disclaimer would allow the retirement benefits to pass directly to the children (assuming they are the contingent beneficiaries of the accounts). This would help the next generation and not further inflate Eve’s future estate taxes.

If Adam’s contingent beneficiary is a charity, and Eve doesn’t need these benefits herself, disclaiming the benefits and allowing them to pass directly to the charity would be a more tax-effective way for Eve to benefit the charity than taking control of the benefits herself and then trying to give them to the charity (because of the income tax strictures on charitable donation deductions).

In the real world, surviving spouses rarely disclaim retirement benefits (or any other inheritance). Nevertheless, these points should be considered before Eve accepts the benefits.

When to Accept the Benefits but Delay the Rollover

There are two age-based situations in which Eve might be better off holding the inherited retirement accounts as “beneficiary” for a while, postponing the rollover to a later date.

If Eve is younger than age 59 and a half, she might want to leave some or all of the benefits in Adam’s name until she reaches that age. Generally, retirement plan distributions to a person under that age are subject to a 10% “extra tax” (in addition to regular income taxes) under § 72(t) of the Tax Code. One of the many exceptions to this tax is for inherited benefits. A beneficiary does not pay the 10% tax on distributions from an inherited plan regardless of whether the beneficiary is under age 59 and a half (and regardless of how old the decedent was). So as long as Eve leaves the benefits in Adam’s name, any distributions she takes will not be subject to that tax. Once she rolls over the benefits to her own account, however, any distributions from the rollover account she takes prior to age 59 and a half will be subject to the tax (unless she qualifies for some other exception to that tax). Unless she is sure she will have no need for these funds prior to that age, she should consider leaving the accounts in Adam’s name until she reaches the aforementioned age. That way she can withdraw from the plan as needed without concern about the 10% tax. She can carry out the rollover after reaching age 59 and a half, when the problem goes away.

The other reason to leave benefits in Adam’s account is if Eve is older than Adam, especially if Eve is approaching or past her own “required beginning date” age. For example, suppose Eve is age 73 (already subject to taking required minimum distributions) and Adam was only 67 (about five years away from becoming subject to RMDs at age 72). As a surviving spouse holding an inherited IRA as beneficiary, Eve is not required to start taking RMDs until the year Adam would have become subject to RMDs–in about five years. If Eve rolls over the IRA right now, however, she will become subject to RMDs immediately, as she is already past her required beginning date. She can leave the IRA in Adam’s name for now, holding it as beneficiary, and not have to take any RMDs for a few more years.

Later, in the year Adam would have reached age 71, she should roll it over to her own IRA. It is desirable to roll it over just before the year she would become subject to RMDs as Adam’s beneficiary, because beneficiary RMDs are larger (based on a single life-expectancy table) than her RMDs from her own account (based on a joint life-expectancy table), so it is desirable to do the rollover just before the year RMDs as beneficiary would kick in.

If leaving the benefits in Adam’s name for any reason, Eve should make sure what will happen to the account if she dies before carrying out the rollover. She should be allowed by the IRA provider or plan administrator to name a successor beneficiary for the account, but if that is not allowed, she may want to move the account to a more-cooperative administrator if possible.

Rolling Over the Benefits

Once Eve decides she wants to keep these inherited benefits, and is past any age-related reason to leave the account in Adam’s name for a while, she needs to look at each type of plan she has inherited and take control of the benefits in the most advantageous manner. For example:

If Adam’s account in his employer’s retirement plan is wholly or partially invested in the employer’s stock, Eve may be eligible for the very favorable tax treatment allowed to “net unrealized appreciation” in such stock. She should not touch this account until a qualified advisor analyzes the best way for her to take advantage of the NUA stock.

If the inherited plan is a “defined benefit plan,” an “individual retirement annuity,” or a plan or IRA that holds an annuity contract or offers annuities as a form of benefit, Eve should work with a financial advisor and the plan administrator to analyze the benefit options available under the plan or contract. For example, Adam’s workplace plan might offer her the choice between a lump sum distribution (that she can roll over to her own IRA) and a life annuity payout as the surviving spouse. As spousal annuities are sometimes subsidized under these plans, she might discover the annuity is worth more than the lump sum.

If not taking an annuity option, Eve will be looking at transferring the money from Adam’s account to her own IRA. But before proceeding with the transfer, one more question: Did Adam have any after-tax money in any account Eve is inheriting? If so, she has a one-time chance to do a “free” or “cheap” Roth conversion.

If Adam had after-tax money in a “qualified plan” (such as a 401(k) plan with his employer), Eve can direct the plan to transfer the after-tax money directly into a Roth IRA in Eve’s name and the pretax money into a traditional IRA in her name, thus effecting a tax-free Roth conversion of Adam’s after-tax money. If Adam had after-tax money in his traditional IRAs, Eve cannot separate the pre- and after-tax money (as can be done with the qualified plan), but she could transfer all of Adam’s traditional IRA balance(s) to a Roth IRA in her name, thus effecting a Roth conversion which is only taxable to the extent of the pretax money. That could be a “cheap conversion” if Adam had a relatively high percentage of after-tax money in his combined IRA balances–which would be unusual. Either way, any ability to convert after-tax money to a Roth IRA may disappear soon if legislation currently under consideration in Washington is enacted, so this option may not be on the menu at all after 2021.

Once past all these (admittedly unusual) considerations, Eve should take care of day-to-day business as she moves Adam’s benefits to her own IRA: First, if Adam was already past his required beginning date when he died, Eve must take the RMD for the year of his death (if he hadn’t done so) before moving any account to her own IRA. Second, she should move the assets using direct transfers from one plan or account to another, not the “60-day” or “indirect” rollover, to minimize the risk of mistakes. Third, she needs to name designated beneficiary(ies) for any rollover account she opens.

Then she’s done, and she and you can take the rest of the day off!

Natalie Choate is a lawyer in Wellesley, Massachusetts, who concentrates in estate planning for retirement benefits. The 2019 edition of Choate’s best-selling book, Life and Death Planning for Retirement Benefits, is available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article do not necessarily reflect the views of Morningstar.