Inherited IRA and Pension Benefits: Key Considerations for Beneficiaries

‍SAN FRANCISCO, CA. Losing a loved one is one of the most difficult emotional experiences a person can face, and unfortunately, it often comes with the added burden of navigating complex financial decisions.

For beneficiaries inheriting retirement assets, such as Individual Retirement Accounts (IRAs) or pensions, understanding the rules and tax implications is crucial for making informed choices. The IRS has strict guidelines that must be followed, and despite the emotional challenges, it’s our responsibility to ensure the necessary taxes are paid. As outlined in Crewe Advisors’ guide to inherited IRAs here, recent changes by the IRS in 2024 have brought new considerations for beneficiaries to keep in mind.

During such a trying time, making financial decisions can feel overwhelming. A few wrong steps could lead to costly mistakes, both financially and emotionally. That's why having the right knowledge and support in place can make all the difference, helping to avoid further complications when the emotional fog begins to lift.
‍
This article provides an overview of inherited IRA rules, pension benefits, and important considerations for beneficiaries.

What Is an Inherited IRA?

An inherited IRA, sometimes called a beneficiary IRA, is an account set up when someone inherits an IRA after the original account owner passes away. The beneficiary can be a spouse, relative, estate, or even a trust. The rules for handling an inherited IRA depend on the relationship to the deceased and the type of IRA being inherited, such as a traditional or Roth IRA. For a deeper dive into the distribution rules and what to expect, ThinkAdvisor provides a thorough explanation here.

Options for Spouses

If you inherit your spouse’s IRA, you have several options:

1. Treat the IRA as Your Own: As a spouse, you can roll the inherited assets into your own IRA, allowing you to delay required minimum distributions (RMDs) until you reach the age of 73. This option can provide continued tax-deferred growth if you don’t need immediate access to the funds.
2. Open an Inherited IRA: Another option is to establish an inherited IRA, which allows you to avoid early withdrawal penalties if you are under the age of 59½. You must begin taking RMDs the year after your spouse’s death, or you can wait until the year they would have turned 73.
3. Roth IRA Considerations: If your spouse had a Roth IRA, and it was funded for at least five years, withdrawals may be tax-free. However, RMDs are required for inherited Roth IRAs, unlike those owned by the original holder.

Options for Non-Spouses

Non-spouse beneficiaries have different rules when inheriting an IRA:

1. 10-Year Rule: Under the SECURE Act, non-spouse beneficiaries must distribute the entire account within 10 years of the original owner’s death. There are no annual distribution requirements, but the entire balance must be withdrawn by the end of the 10th year. For more on this, Reynolds + Rowella LLP clarifies the 10-year rule here.
2. Eligible Designated Beneficiaries: Some non-spouse beneficiaries, such as minor children, individuals with disabilities, or those within 10 years of the deceased’s age, may qualify for extended distribution options based on life expectancy.
3. Lump-Sum Distribution: Non-spouse beneficiaries also have the option to take a lump-sum distribution, but this could lead to significant tax consequences, especially if the account is large.

Understanding Pension Inheritance

In addition to IRAs, some individuals may inherit pension benefits from a deceased parent or spouse. Pension plans vary based on the employer and plan structure, but here are some common scenarios:

1. Spousal Pension Benefits: Many pension plans offer survivor benefits to spouses, often in the form of annuity payments. These payments may continue for the spouse’s lifetime, but the amount is usually lower than the original benefit received by the participant.
2. Non-Spouse Beneficiaries: In certain cases, non-spouse beneficiaries, such as children, may be eligible to inherit pension benefits. This is typically allowed if the plan participant selected an option that provides benefits for a certain period, such as a "period certain" annuity. If the participant dies before the period ends, beneficiaries receive the remaining payments.
3. Defined Benefit vs. Defined Contribution Plans: Pension benefits are often categorized into defined benefit or defined contribution plans. Defined benefit plans guarantee a set payout for life, while defined contribution plans, such as 401(k)s, allow beneficiaries to inherit the account balance and withdraw funds gradually, or as a lump sum.

Tax Implications

The tax treatment of inherited IRAs and pensions depends on the type of account and the relationship of the beneficiary to the deceased. Here are some key points:

• Traditional IRAs: Distributions from inherited traditional IRAs are generally subject to income tax. Spouses rolling over the account into their own IRA may delay taxes, while non-spouse beneficiaries should plan withdrawals carefully to avoid significant tax liabilities in any given year.
• Roth IRAs: As long as the Roth IRA was funded for at least five years, beneficiaries may enjoy tax-free withdrawals. However, RMDs are still required for non-spouse beneficiaries under the inherited Roth IRA rules.
• Pension Benefits: Pensions can be paid out as lump sums or annuities, with the tax treatment depending on the payout structure. In most cases, pension benefits inherited by spouses or children are not subject to estate taxes.

And, as a teacher in California, you're likely familiar with the complexities of retirement benefits, such as those from CalSTRS (California State Teachers' Retirement System). 

If you inherit an IRA or pension, understanding the nuances of inherited retirement assets can be especially important to avoid unexpected tax burdens and maximize your financial legacy. For instance, California's state income tax on inherited IRAs can significantly impact your decisions, especially when coupled with federal tax implications. 

As an educator, navigating these financial choices with care is essential, whether it's rolling over an inherited IRA or managing pension benefits. 

Key Takeaways

Managing an inherited IRA or pension benefit involves making important decisions that could affect your financial future. Consulting with a fiduciary financial professional can help you understand the specific options available to you and how best to minimize taxes or maximize growth. Be sure to review the retirement plan’s rules and consult a tax advisor to avoid unexpected penalties.

By understanding your options, you can make informed decisions that align with your financial goals and honor the legacy of your loved one.

‍