When an individual passes away leaving a surviving spouse, the tendency is for the survivor to self-administer the inherited assets. The surviving spouse might think the assets are just their own.
They are unaware that there are important decisions to be made that can have serious legal and tax consequences. When someone passes away is one time it’s essential to consult with an estate planning lawyer, a tax advisor like a CPA or enrolled agent, and possibly a financial planner.
The IRS recently issued proposed and final regulations that explain the rules as modified by the SECURE Act of 2017 and SECURE 2.0 Act of 2022 for inherited retirement accounts, including traditional IRAs, Roth IRAs, employer retirement plans like 401(k)s, and employer plan designated Roth accounts (DRACs).
The rules are too complex to explain in detail here. I am just going to highlight a couple of items for surviving spouses.
Some time ago, one of our senior gentleman clients married a much younger lady and, soon after their marriage, he passed away. He named her as the sole beneficiary of his traditional IRA. Before consulting with us, the surviving spouse rolled the IRA to her own IRA account. She wanted to take large distributions from the account, and she was under age 59 1/2. We had to explain to her that large distributions from her own account would be subject to a 10% federal tax penalty plus a 2.5% California tax penalty. Smaller distributions taken as a series of substantially equal payments could be made penalty-free.
You can’t “undo” a rollover from an inherited retirement account to your own account, so she was “stuck”.
If she had transferred the account to a separate beneficiary account, she could have received large distributions penalty-free.
This rule still applies under the new regulations.
Effective for surviving spouse beneficiaries whose first required minimum distribution (RBD) year is 2024 or later (usually when the account owner was deceased during 2023 or later), rules for sole beneficiary spouse accounts have changed. The surviving spouse isn’t required to start distributions until the year in which the account owner would have reached his or her Applicable Age (currently age 73); and, when payments commence, they are based on the Uniform Lifetime Table with the surviving spouse treated as the owner, recalculated annually. (Note: When the terms of the plan state the account must be distributed within 10 years, the terms control and these life expectancy distribution rules don’t apply.)
Before these changes, the surviving spouse was required to start taking distributions for the year after the account owner’s death, and the payments were based on the Single Life Table using the surviving spouse’s age, recalculated annually. (Distributions computed using the Uniform Lifetime Table are smaller than those computed using the Single Life Table.)
The surviving spouse still might decide to roll the beneficiary account to his or her own after reaching age 59 1/2. An important difference for their own account is, if they remarry and name their new spouse as the sole beneficiary of that account, the new spouse will be able to roll the account to their own account. A new spouse doesn’t have that option when named as a successor beneficiary of their deceased spouse’s beneficiary account. (Remember to name beneficiaries for a beneficiary account and for your own account.)
Remember the federal penalty for not taking RMDs is 25% of the shortfall, with procedures available to reduce the penalty. See your tax advisor for details.
There are other important decisions to be made not covered here, including distribution rules for employer accounts with both traditional/taxable and DRAC components, and potential Roth conversion alternatives.
This blog post is an alert for surviving spouses to avoid a potential tax blunder. Please consult with your own attorney and tax advisor.