Retirement plans and death benefits come in many forms, and the rules differ from one type to another. If you receive a death benefit from an employer’s retirement plan when your spouse dies, it may be subject to taxes, but that depends on the type of plan it is, whether it’s a payout of the plan or whether the employer provides additional benefits.
Employer Sponsored Plans
If you receive a death benefit from an employer-sponsored plan such as a 401(k) or a 403(b), you actually receive the balance of the account itself, rather than a benefit issued by the plan’s provider. As the plan’s beneficiary, you’ll owe income tax on the amount, but only when you take a distribution from the amount. Opting for a lump-sum payout of the plan might result in being taxed at a higher rate: For example, if you receive $500,000 in a 401(k) and take it all at once, you’ll be taxed at the highest rate -- 39.6 percent as of 2013 -- but if you take distributions of $50,000 annually, you’ll only face 25 percent taxes on the amount if that’s your only income for the year.
Many pension plans allow you to choose to take a smaller pension each year so your spouse will continue to receive benefits after your death. In this case, the Internal Revenue Service treats the pension benefit as if it were yours. The IRS treats pension payments as deferred compensation for work done in the past and taxes them as ordinary income. You’ll owe taxes on each payment at your normal rate, which hinges on your other earnings through the year.
Life Insurance Benefits
If the employer’s retirement plan included a life insurance policy that serves as a death benefit, it’s likely that most of the benefit will escape taxation. You always receive the policy’s listed benefit tax free, but any additional amount, such as extra interest earned on the policy, is subject to income tax. For example, if you’re the beneficiary of a $100,000 life insurance policy provided by your husband’s employer, and you receive $102,500 when he dies, only the excess $2,500 is taxable.
Other Retirement Plans
Employee-owned retirement plans such as individual retirement accounts and Roth IRAs don’t provide a specific death benefit, but they can be inherited by a beneficiary. While the value of these plans is considered part of the deceased’s estate when calculating estate taxes, they bypass probate and become property of the beneficiary who's named for each account. You’ll owe taxes on distributions taken from any qualified account to which contributions were made on a pretax basis, including IRAs, Simplified Employee Pension -- or SEP -- IRAs and Savings Incentive Match Plan for Employees, or SIMPLE IRAs. If contributions were made after taxes, such as with a Roth IRA, you receive distributions from the account tax free.
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