If your spouse passes away and they had either an IRA, 401(k), 403(b), or some other type of employer sponsored retirement account, you will have to determine which distribution option is the right one for you. There are deadlines that you will need to be aware of, different tax implications based on the option that you choose, forms that need to be completed, and accounts that may need to be established.
Spouse Distribution Options
As the spouse, if you are listed as primary beneficiary on a retirement account or IRA, you have more options available to you than a non-spouse beneficiary. Both spouse and non-spouse beneficiaries are allowed to:
- Take a cash distribution
- Rollover the balance to an inherited IRA
But as the spouse of the decedent, you also have a third option:
- Rollover the balance into your own IRA
To determine which option is the right choice, you will need to take the following factors into consideration:
- Your age
- The age of your spouse
- Will you need to take money from the IRA to supplement your income?
We will start with the most basic option which is to take a cash distribution directly from your spouse’s retirement account. Be very careful with this option. When you take a cash distribution from a pre-tax retirement account, you will have to pay income tax on the amount that is distributed to you. For example, if your spouse had $50,000 in a 401(k), and you decide to take the full amount out in the form of a lump sum distribution, the full $50,000 will be counted as taxable income to you in the year that the distribution takes place. It’s like receiving a paycheck from your employer for $50,000 with no taxes taken out. When you go to file your taxes the following year, a big tax bill will probably be waiting for you.
In most cases, if you need some or all of the cash from a 401(k) account or an IRA, it usually makes more sense to first rollover the entire balance into an inherited IRA, and then take the cash that you need from there. This strategy gives you more control over the timing of the distributions which may help you to save some money in taxes. If as the spouse, you need the $50,000, but you really need $30,000 now and $20,000 in 6 months, you can rollover the full $50,000 balance to the inherited IRA, take $30,000 from the IRA this year, and take the additional $20,000 on January 2nd the following year so it spreads the tax liability between two tax years.
10% Early Withdrawal Penalty
Typically, if you are under the age of 59½, and you take a distribution from a retirement account, you incur not only taxes but also a 10% early withdrawal penalty on the amount this is distributed from the account. This is not the case when you take a cash distribution, as a beneficiary, directly from the decedents retirement account. You have to report the distribution as taxable income but you do not incur the 10% early withdrawal penalty, regardless of your age.
Let’s move onto the two IRA options that are available to spouse beneficiaries. The spouse has the decide whether to:
- Rollover the balance into their own IRA
- Rollover the balance into an inherited IRA
By processing a direct rollover to an IRA in either case, the beneficiary is able to avoid immediate taxation on the balance in the account. However, it’s very important to understand the difference between these two options because all too often this is where the surviving spouse makes the wrong decision. In most cases, once this decision is made, it cannot be reversed.
Spouse IRA vs Inherited IRA
Unlike non-spouse beneficiaries, the spouse has the option of rolling over their spouse’s 401(k) or IRA into their own IRA. Non-spouse beneficiary are not given this option. Non-spouse beneficiaries either have to take a cash distribution or rollover the balance to an inherited IRA. Once a non-spouse beneficiary completes the rollover into the inherited IRA, they have to begin taking required minimum distributions (RMD’s) from the account each year. Those RMD’s are required to begin by December 31st following the decedent’s date of death and the beneficiary is taxed on those amounts.
Here is where the issue lies. There is common misunderstanding of the RMD rules when it comes to inherited IRA’s. The spouse often assumes that if they select the inherited IRA option, they too will be forced to take an RMD each year just like the non-spouse beneficiaries. That is not necessarily true. When the spouses establishes an inherited IRA, a RMD is only required when the deceases spouse would have reached age 70½. This determination is based on the age that your spouse would have been if they were still alive. If they are under that “would be” age, the surviving spouse is not required to take an RMD from the inherited IRA for that tax year.
For example, if you are 39 and your spouse passed away last year at the age of 41, if you establish an inherited IRA, you would not be required to take an RMD from your inherited IRA for 29 years which is when your spouse would have turned age 70½. In the next section, I will explain why this matters.
Surviving Spouse Under The Age of 59½
As the surviving spouse, if you are under that age of 59½, the decision between either establishing an inherited IRA or rolling over the balance into your own IRA is extremely important. Here’s why .
If you rollover the balance to your own IRA and you need to take a distribution from that account prior to reaching age 59½, you will incur both taxes and the 10% early withdrawal penalty on the amount of the distribution.
But wait…….I thought you said the 10% early withdrawal penalty does not apply?
The 10% early withdrawal penalty does not apply for distributions from an “inherited IRA” or for distributions to a beneficiary directly from the decedents retirement account. However, since you moved the balance into your own IRA, you have essentially forfeited the ability to avoid the 10% early withdrawal penalty for distributions taken before age 59½.
The Switch Strategy
There is also a little know “switch strategy” for the surviving spouse. Even if you initially elect to rollover the balance to an inherited IRA to maintain the ability to take penalty free withdrawals prior to age 59½, at any time, you can elect to rollover that inherited IRA balance into your own IRA.
Why would you do this? If there is a big age gap between you and your spouse, you may decide to transition your inherited IRA to your own IRA prior to age 59½. Example, let’s assume the age gap between you and your spouse was 15 years. In the year that you turn age 55, your spouse would have turned age 70½. If the balance remains in the inherited IRA, as the spouse, you would have to take an RMD for that tax year. If you do not need the additional income, you can choose to rollover the balance from your inherited IRA to your own IRA and you will avoid the RMD requirement. However, in doing so, you also lose the ability to take withdrawals from the IRA without the 10% early withdrawal penalty between ages 55 to 59½. Based on your financial situation, you will have to determine whether or not the “switch strategy” makes sense for you.
The Spousal IRA
So when does it make sense to rollover your spouse’s IRA or retirement account into your own IRA? There are two scenarios where this may be the right solution:
- The surviving spouse is already age 59½ or older
- The surviving spouse is under the age of 59½ but they know with 100% certainty that they will not have to access the IRA assets prior to reaching age 59½
If the surviving spouse is already 59½ or older, they do not have to worry about the 10% early withdrawal penalty.
For the second scenarios, even though this may be a valid reason, it begs the question: “If you are under the age of 59½ and you have the option of changing the inherited IRA to your own IRA at any time, why take the risk?”
As the spouse you can switch from inherited IRA to your own IRA but you are not allowed to switch from your own IRA to an inherited IRA down the road.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.