Updated: Feb 3
After you lose your spouse, the memories keep coming. You continually encounter little reminders, like the refreshed washer and dryer that he, dressed out in a too-tight Tyvek suit, spray-painted in the garage. One of the biggest reminders of how much he loved you is the 401(k) or IRA he built over his long career that will now wrap its arms around you and help keep you financially safe.
In our series on how to manage finances after the death of a spouse, we’re exploring tips from FINRA, a reliable financial source. Today, Tip 6a: Your Spouse’s IRA and 401(k) - Definitions.
Tax Considerations and A Long Definition of the Required Minimum Distribution (RMD)
The complications of the 401(k) and IRA lie in their special category as tax-deferred retirement accounts. All this extra stuff and all these extra rules result from the fact that taxes get special treatment, and of course no government wants to miss out forever on possible tax revenue!
Here’s the difference: when you save money in a regular bank or brokerage account, you’ve already paid taxes on the money that you put into those accounts, and each year when you make money through interest or stock sales, you pay taxes on those gains. However, in any Traditional 401(k) or IRA retirement account, you are putting in money that you haven’t paid tax on yet and any money you make in those accounts has also not been taxed.
So, when you want to take that money out of the special Traditional 401(k) or IRA, you need to pay tax. And because the government doesn’t want you to be able to keep that money tax free forever for yourself (and your heirs), they have rules for when you have to take it out so that it can be taxed. One of the rules is the Required Minimum Distribution (RMD) that requires partial withdrawals from that account when you are “old” (age 70 ½ until the recent SECURE Act legislated a few extra months before you have to start).
Different Rules for Inheriting from a Spouse Rather Than from Others
This article is about inheriting a Traditional 401(k) or IRA retirement account from a spouse, which has different rules than if you were to inherit from anyone else, like a parent, sibling, or other relative or friend. As we discussed above, our government wants to make sure that tax is paid on income. When you defer as much as $18K+ of taxable income year after year over a 30+ year career, that’s a lot of income that hasn’t been taxed. And if the account does well and provides a strong return, that’s even more money that still hasn’t been taxed.
The government makes you take RMDs so that your accumulated previously un-taxed retirement savings get taxed. If you die before you’ve had a chance to take most of that money out and you’ve left it to a child, the government might miss out on decades when it could collect tax on that money if the child were to be able to wait until he or she got to 71+ before paying the tax.
But for spouses inheriting each others’ Traditional 401(k) or IRA retirement account, the government cuts you a bit of a break. Most spouses are around the same age, so usually a person doesn’t get to hold off for decades in taking RMDs, so the rule allows you as the surviving spouse to roll your deceased spouses’ Traditional 401(k) or IRA retirement account into your own and then use your own RMD calculations for withdrawing that money.
You can read more in FINRA’s report, Smart Management of Retirement Income. We’ll continue to cover FINRA’s tips for widows in the next few articles. Tip 6b: Your Spouse’s IRA and 401(k) – Options on What to Do. Thank you for joining me.
Kathryn Hauer, a Certified Financial Planner ™, adjunct professor, and financial literacy educator has written numerous articles and several books including the "11-Step, DIY, Comprehensive Financial Plan Workbook" and "Financial Advice for Blue Collar America." She works to help clients and readers understand and act on complex financial information to keep them and their money safe. She functions as a strong advocate and guiding light for her clients as they move through a murky and unfamiliar financial world. Learn more at her website.