There are many financial decisions that a widow has to face in the early days after the loss of a spouse. Deciding how to handle the assets that come to you from Traditional Individual Retirement Accounts (IRAs) that were owned by your spouse is one of them. The rules can be complicated, and making an uninformed decision may result in having less of the money that was left to you to support yourself and your family. While we suggest that you consult with both tax and financial advisors to help you make the best decision, here are a few things to know.
There are four main options a widowed spouse can make when it comes to inheriting Traditional IRA assets as a direct beneficiary (i.e. not through a trust). Those options are:
1. Rollover assets into an IRA in your name
2. Rollover the assets into an Inherited IRA account
3. Take the assets out for spending
4. Convert the assets to a Roth IRA
A fifth option, disclaiming all or part of the assets, may apply if you think including the inherited assets could result in your estate exceeding the federal estate tax exemption limit for married couples which is approximately $11.2 million for 2018. If this pertains to you, then you’ll want to add disclaiming assets to the list and consult with an attorney.
One overarching rule to remember is that the tax rules differ when you are the deceased’s spouse. For rules pertaining to non-spouse inherited IRAs, read: Inherited IRA Rules That Non-Spouse Beneficiaries Need To Know.
If you inherit your spouse’s IRA, consider these tips before deciding between the four options:
Surviving spouses are the only inheritors allowed to rollover assets into an IRA in their own name. This may be a good option if you don’t need the money in the near future, or if you can afford to hold the assets in the IRA to take advantage of its tax-favored status. If you don’t need the income or assets before age 59 ½, rolling them over into your own IRA will allow you to delay taking required minimum distributions (RMDs) until you reach age 70 ½. Keep in mind that if you need to access these assets and you are under age 59 ½, you’ll pay a 10% penalty if they are withdrawn from a Traditional IRA in your name. Having a long-range financial plan is the best way to know whether you will need this money now or if you can likely keep it invested until you turn 70 ½.
Choosing to rollover the IRA to an inherited IRA may be a good choice if you’re under age 59½ and need the income or assets now, because withdrawals are not subject to a 10% penalty. You can withdraw any amount as long as you meet the RMDs starting in the year after the year of your spouse’s death. You can also choose to delay taking RMDs until the year your spouse would have turned age 70½. Since the penalty isn’t an issue in this decision, one main consideration is how withdrawals will impact your total income tax bill.
You can also invoke the 5-year rule that applies to rollovers to an inherited IRA. If your spouse was younger than age 70½ when he or she died, you can take up to 5 years to withdraw assets from an inherited IRA. However, the rule requires that all assets be withdrawn by December 31 of the fifth year after your spouse's death. Because of that provision, you’d want to choose this option only if you’re willing to incur the income taxes associated with each withdrawal and the requirement to take everything out of the account within five years.
Your age matters if you don’t rollover the account but instead take the assets out for spending. You will pay a 10% early withdrawal penalty if you are under age 59 ½. In addition, these funds become taxable to you as ordinary income. If you are younger than 59 ½ when you inherit the funds, we typically advise rolling over the assets into either your own or an inherited IRA unless you have no other source of income or means to support your costs of living.
RMD rules can be confusing for inheritors, especially if their spouse passed away at age 70½ or older. The confusion comes from the tax requirement that the deceased must take their RMD for the year in which he or she passed away. If they didn’t take it before death, then the inheriting spouse must take the withdrawal before the end of the year of their spouse’s death.
Beware of the tax monster
As mentioned before, taking a full distribution for an IRA could significantly reduce the amount of money you will have to spend because of the impact of taxes and potential penalties. What often gets missed in analyzing the option of taking a partial or full withdrawal is the impact a distribution has on your overall marginal tax bracket. Distributions you take from an inherited IRA will generally be taxed as ordinary income, no matter your age. That increase in income could move you into a higher tax bracket, meaning you’ll pay more of the distribution out to cover federal income taxes.
Depending on the size of the IRA distribution, there may be other income tax consequences such as higher capital gains tax rates, a reduction in deductions, and Alternative Minimum Tax implications. If you’re thinking about taking a full distribution, we recommend that you consult with a CPA to determine your options and the potential tax consequences. If possible, you may want to consider splitting your withdrawals over at least two tax years as a way to potentially reduce your total taxes.
Consider all sources of income and assets
Another way to determine which of the four options suits your needs is to analyze your overall financial picture. Compiling a comprehensive balance sheet and preparing a long range financial plan is one of the best ways to understand all the resources you have available for meeting your income and support needs for the remainder of your life. It’s only after this analysis that you can determine whether immediate use of the funds is necessary or whether you can take advantage of any tax-deferred growth by choosing one of the rollover options. If you decide that liquidating the IRA and taking a distribution is your best choice, be sure to set aside enough cash to pay the taxes. If you don’t reserve that cash up front, you could be hit with a big tax surprise and need to scramble for cash to pay your tax bill the following April.
The fourth option, converting the assets to a Roth IRA, requires a more detailed review of your income and assets and should only be considered with the help of a CPA and/or a financial advisor. This analysis is important because you will be required to pay ordinary income tax on amounts you convert from an inherited IRA into a Roth IRA. This option usually makes sense only when you have sufficient liquid assets to pay the conversion tax and if you also expect to be in a higher tax bracket in the future.
Ask for help
Even if you navigate the decision-making without the help of a financial expert, you may want or need to ask for advice as you complete the required paperwork to execute your decision since the forms for either a distribution or rollovers can be complicated. Even with the conviction that you’ve made the right decision, you’ll need to be sure the custodian or holder of the assets executes your decision properly. If you decide to rollover assets, make sure the assets transfer directly from your spouse’s account to the new account. You don’t want to receive a check as that runs the risk of being considered a taxable distribution.
For an inherited IRA, the account titling is important and should include the name of the deceased, your name, and specify that it’s a beneficiary IRA. Do not comingle an IRA inherited from your spouse with other IRAs you’ve inherited because RMD and other rules differ. And no matter which option you choose for taking the assets, you’ll want to pay attention to the documents you receive, including initial statements that record the transaction(s) and tax forms you will receive in the following calendar year.
Consider your legacy
If you choose to rollover funds to either an inherited IRA or an IRA of your own, be sure to designate your beneficiary when you open the account. That may require you to consult with an estate planning attorney, especially if you’re considering beneficiaries who are minors. Beneficiary designations are included in the initial account opening paperwork so carefully consider your options when completing those forms. For more information, read: 7 Common Mistakes to Avoid When Naming Your Beneficiaries.
Analyzing your options involves an understanding of complex tax laws plus consideration of many dimensions of your wealth including your age, the age of your spouse, income, other assets, and spending needs, to name just a few. We highly recommend that you carefully weigh your options and ask for help from your financial advisor or CPA so that you make the best decision for your situation.
Consider this your training manual to get and stay financially fit for life!