After a lifetime of hard work and pinching pennies to fund your retirement, it's only natural to want to make sure any portions of it you don't use in your lifetime pass on to your children when you die -- either as defined by your will or as beneficiary accounts. The good news is, most of the money will. However, when your kids inherit retirement accounts, the tax rules are a little trickier than if you willed them stacks of cash.
After you die, most retirement accounts like 401(k)s and traditional and Roth IRAs are treated a little differently from conventional assets. Bank accounts and property head through probate. If you officially name a beneficiary for your retirement account, your heir receives the account itself, including any tax advantages it has over cash. If you don't name one or make your estate an account's beneficiary, your heirs lose the tax perks that come with retirement plans. The court cashes out your savings and divvies up the balance between your children. Because of this, it’s vital to name your children as beneficiaries of your retirement accounts.
When your children receive your nest egg, they have the option to cash out the account -- usually within a period of five years -- or convert it to a beneficiary IRA. If they inherit a 401(k), they'll need to roll over the funds to a beneficiary IRA or cash it out. Your children won't be able to add money to inherited IRAs, but the Internal Revenue Service allows them to maintain these as beneficiary accounts. The money grows tax-free as in a traditional or Roth IRA, but your children must make withdrawals each year, based on the balance and their projected lifespans.
If you leave your children a Roth IRA, after estate taxes, they’ll be able to withdraw money from their inheritance without paying additional taxes. If that stash of cash comes as a traditional IRA or 401(k) that they roll over to a beneficiary IRA, they must pay taxes on every penny they take out of the account as if it were earned income. Because of this, if your children choose to cash out a large IRA, the amount may push them into a higher tax bracket than if they took smaller required minimum distributions throughout their life.
If your retirement includes a pension, you’re out of luck. While some funds may allow you to take a reduced pension amount so your spouse can continue to receive you pension when you die, you can't pass it on to your children. Some retirees opt to receive their pension as a lump-sum payout instead of a traditional annual payment, so they can invest it in other forms that may be inherited by their children.
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- Can an Inherited 401(k) Be Rolled Over to an IRA?