What happens to your 'qualified' money at death?
September 17, 2012
by Brian Wolf

The death of a family member is obviously a very challenging and emotional time, and not long after the death, more challenging financial issues will arise.

The following is just one of many very important issues that will need to be addressed.

Often, the beneficiary of a qualified account like an IRA, 401(k), or 403(b) is a surviving spouse. A surviving spouse, unlike any other beneficiary, may do a rollover of the qualified money into an IRA in the survivor’s own name. A common question is whether there are tax benefits to maintaining the current account, as an inherited account or should the surviving spouse do a rollover into their own name.

Ordinarily, distributions from a qualified account prior to age 59-1/2 are subject to a 10 percent early distribution penalty, unless the distribution falls under some exception, such as disability or taking a series of substantially equal periodic payments based on life expectancy. In addition, IRAs have other exceptions, such as first-time home buyer, college education expense, and several others. Another major exception to the penalty is a distribution due to the death of the owner.

Thus, if a surviving spouse under the age of 59-1/2 maintains the money as an inherited account, they may make withdrawals at any time for any purpose without the 10 percent penalty as a distribution because of the death of the owner, the deceased spouse.

If the surviving spouse beneficiary rolls the money into an IRA in their own name, any distributions prior to age 59-1/2 generally will be subject to the 10 percent penalty, unless it falls under one of the exceptions. Thus, a surviving spouse under age 50-1/2 who anticipates needing to pull out money prior to age 59-1/2 for some purpose not covered by an exception should think twice before doing a rollover into the survivor’s own IRA.

On the other hand, maintaining the account as an inherited account does pose some drawbacks from the standpoint of the required minimum distribution (RMD) rules.

If a surviving spouse rolls the inherited account into an IRA in their own name, the RMDs will be based on their age. If they are under age 70-1/2, there will be no RMDs required. If they are over age 70-1/2, there will be RMDs based on their own age.

If the account is maintained as an inherited account, the RMDs will be governed by the deceased spouse’s age. If the deceased spouse was younger than age 70-1/2, then no RMDs from the inherited account are due, until the year the deceased spouse would have attained age 70-1/2 had they lived.

In the year the deceased spouse would have attained age 70-1/2, and each year thereafter, an RMD from an inherited account must be taken. The beneficiary spouse may base the payout on either the age of the deceased spouse or their own age. If the deceased spouse was older than the survivor, then the survivor would probably elect to base the payouts on their own age. Unlike a rollover, a surviving spouse beneficiary may have to take RMDs from an inherited account prior to reaching age 70-1/2.

The RMD rules pose another drawback to choosing to treat an IRA as an inherited account. If the family wishes to delay payout of the account for more than one generation, they can’t do it with an inherited IRA. If the surviving spouse maintains the account as an inherited account and dies prior to exhaustion of the account, the children will inherit the account, but cannot stretch out the payments of the RMDs based on their ages. They will have to liquidate the account based on the surviving spouse’s age.

On the other hand, if the surviving spouse rolls over the account into their own name, they may then name children as the beneficiary, and on their subsequent death the children may do a stretch rollover based on their own respective ages. Being able to stretch the RMDs out over the lifetime of the child could be a tremendous financial advantage.

By now, I’m sure I’ve lost most readers with all this mumble jumble financial jargon. The main take-away here is that it’s very, very important to work with a very knowledgeable and qualified financial professional when it comes to making your financial decision before, as well as after a death in the family.

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