“And two shall become one.” Traditional marriage vows included that phrase, and maybe you remember hearing that at your wedding. After decades of marriage, you two crystallized into a unified entity of one: one tax return, one home, one bar of soap, one opinion on the Super Bowl halftime show. After the death of a spouse, “two shall become one” applies to inherited retirement accounts as well.
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 6b: Your Spouse’s IRA and 401(k) – Options on What to Do.
In our previous article, Tip 6a, we talked about how retirement accounts like 401(k)’s and IRAs have rules that are different from other kinds of financial account vehicles. When you inherit your spouse’s 401(k) or IRA (unlike if you were to inherit from someone else like a parent, sibling, child, or other person), that spousal 401(k) or IRA becomes your own. That makes inheriting a 401(k) or IRA from a spouse much easier and simpler.
Options for an Inherited Spousal 401(k) or IRA
As the IRS explains, you have three choices to make it your own. You can:
· Option 1 – Roll it over into your own IRA in your name
· Option 2 – Designate yourself as the account owner
· Option 3 – Keep yourself as the beneficiary
· Option 4 – Take a distribution (i.e., cash it in)
For Option 1, you would contact the entity that holds the account, whether it is your spouse’s company for a 401(k) or the brokerage holding the IRA, and complete the paperwork to make that account your own in your name. It will then be no different from any retirement account that you might have set up for yourself.
In Option 2 you would leave the account as is but complete the paperwork that makes you the account holder. This option is very close to Option 1 but allows you to leave it in the same account your spouse had it in. You might want to do that if, for example, that account has mutual funds that are unique to that particular 401(k) or IRA and you don’t want to liquidate them at this time, which you might need to do if moving to your own IRA at a different brokerage house.
You might want to choose Option 3 if, as the IRS writes, “you're under the age of 59½ or you're older than your spouse. When you set the account up so you're considered the beneficiary of the inherited IRA instead of the owner, your required minimum distributions (RMDs) are determined by your spouse's age at the time of his death. This presents two possibilities. The advantage of this choice is that you can take withdrawals if necessary and no penalty tax will apply if you're not yet 59½. And if you're older than your spouse, you can defer the RMDs until your spouse would have been required to take them, which will be a later date.”
It is unlikely that you would want to choose Option 4, especially if the account is a Traditional IRA or 401(k) because you would need to pay income tax on the lump sum, which could be hefty. And if you are younger than 59 ½, you will likely pay a 10 percent penalty.
The Difference Between a 401(k) and IRA
One note on the distinction between a “401(k)” and an “IRA” – if your spouse’s retirement account is a 401(k) from work after death it is probably going to become an IRA rather than a 401(k). The 401(k) is a retirement vehicle offered by a company to its employees. A “regular person” can’t start or open his or her own 401(k), unfortunately, because the 401(k) is a good deal. For example, if you work for a company that offers a 401(k) plan, you can contribute up to $19,500 per year in 2020 to that plan. If you don’t work for a company with a 401(k) or if you are self-employed, then the most you can do is contribute up to $6,000 annually in 2020 to an IRA. That huge difference is one of the reasons a 401(k) is a great employee benefit. So, once your spouse is no longer with you and cannot be an employee of that company, it is likely that the company will help you move that 401(k) money into an IRA. Some companies will allow you to leave the money in their 401(k) plan with you as the beneficiary or account holder, but it is usually preferable to move it into an IRA so that you have more investment choices and more control. Companies merge, change ownership, pick new401(k) custodians, outsource benefits/HR functions, etc., and since your spouse isn’t an employee there, it can get harder and harder to access and manage the funds in that 401(k).
You can read more in FINRA’s Investor Alert on Inherited IRAs: What You Need to Know. We’ll continue to cover FINRA’s tips for widows in the next few articles. Tip 7 offers suggestions on what to change and when with regard to checking and other accounts. 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.