The rules for inheriting a 401(K) have been revamped – everything you need to know and how to avoid a shock bill

Retirement accounts are an important part of the financial assets that many Americans plan to pass down to family.

But the constantly changing rules mean that many people are confused about what is required of them if they inherit a 401(K) or an IRA.

The rules around inheritance of retirement accounts are complex and depend on the type of plan and the relationship between the beneficiary and the original owner.

But it’s essential to understand these rules to avoid a shocking tax bill, experts warn.

The Internal Revenue Service (IRS) requires Americans who inherit retirement accounts to withdraw savings over a certain period of time, in what are known as required minimum distributions (RMDs).

“The rules governing retirement plans — 401(k) or IRAs — are designed to ensure that when the accounts are inherited, they don’t benefit from tax-deferred growth indefinitely,” Peter Gallagher, director, told DailyMail. manager of the Unified Retirement Planning Group. com.

“The IRS wants to make sure they get their money at some point.”

The rules surrounding these withdrawals have changed from time to time in just the past few years, leaving many people confused about where they stand, Gallagher said.

The original SECURE Act, which went into effect in 2020, and more recently the SECURE Act 2.0, have brought sweeping changes to legacy retirement accounts.

Under these rules, most accounts inherited by non-spousal beneficiaries must be cleared within 10 years of the original owner’s death.

In the past, beneficiaries could ‘stretch’ withdrawals over their lifetime, which potentially reduced the tax burden.

For example, people were leaving an IRA to their grandchildren, and their life expectancy was so long that the IRS wasn’t generating much tax from it, Gallagher said.

The new law made an exception, however, allowing certain ‘certain qualified beneficiaries’ to continue to be eligible for the extended IRA rule.

These people include surviving spouses, minor children under the age of 21, and people with disabilities.

Generally, IRA owners must take their first RMD by April 1 of the year after they turn age 73. This date is called their required start date.

Due to changes in federal law that took effect in 2023, the age at which Americans must begin taking RMDs may vary depending on the year they were born.

The type of beneficiary of an inherited retirement account and whether the original owner had begun taking RMDs at the time of their death will determine the rules around withdrawals, Gallagher explained.

And under new rules introduced this year, if an IRA or 401(K) holder dies while they’ve already started taking RMDs, then the new owner will have to take annual withdrawals for years one through nine of the 10 term. – year old.

This additional provision has been controversial and caused more confusion, so for the fourth year in a row the IRS announced earlier this year that there would be no penalty for not taking these RMDs.

The mandatory annual withdrawal rule also does not apply to inherited Roth IRA accounts, regardless of the age of the deceased.

This means that these accounts can be grown tax-free and withdrawn tax-free in the future.

Gallagher recommends speaking with a tax professional to make sure you understand the rules that apply to your specific situation before planning any withdrawal strategies.

“One of the most important things to keep in mind if you’re a beneficiary is that when you take withdrawals, these will most likely be taxable to you,” he said.

He recommends that you look into the proposed changes from the IRS and speak with a certified public accountant (CPA), a tax advisor or a tax attorney.

This is to ensure that the amount you have to withdraw – along with other income you receive – will not push you into a higher tax bracket.

A tax professional may be able to offer strategies to help lower your taxes each year and ensure you don’t take a big hit, he said.

“It can be mixed feelings for many people because firstly they have lost a loved one and secondly they have more taxable income. And people generally don’t complain about it until they get their tax bill and realize they had no idea the implications.

“If you get the wrong advice, it can be really disastrous from a tax point of view.”

Gallagher also cautions Americans to make sure they have someone listed as a beneficiary for their retirement accounts.

Failure to do so could mean someone’s accounts go into their estate when they die, causing delays or a lengthy probate process for their family.

“I always tell everybody to just list someone as your beneficiary and you can always change it,” Gallagher said.

Along with talking to a tax professional, he suggests potentially opting out of 1/10 of the withdrawal each year.

Although there’s no telling what might happen to the tax bracket in future years, he said, letting it drop in the ninth or tenth year could mean you’re taxed in a higher bracket.

Choosing to take a smaller portion each year would mean spreading the tax consequences.

For example, if you inherit a large IRA, you might decide to take $200,000 a year for 10 years, instead of $2 million in the tenth year.