Taxation of Retirement Funds on a Beneficiary
When you inherit a retirement account from a loved one, you may or may not be required to pay taxes on the inheritance. Whether you are liable for taxes depends on what type of account you inherit. You'll need to determine what taxes you are responsible for, since this affects how much your inheritance will be.
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Traditional Retirement Plans
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Traditional retirement plans include Traditional IRAs and 401k plans. These plans accept pretax or tax deductible contributions. When you inherit the plan, you are required to pay taxes on all funds that have not yet been taxed. This means when you take the inheritance you must pay ordinary income tax on the full amount you receive. If you are the spouse of the deceased, you may defer these taxes by keeping the retirement account and treating it as your own. However, you eventually must pay taxes when you take distributions from the account.
Roth Retirement Plans
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Roth retirement plans --- Roth IRAs and Roth 401k accounts --- accept only after-tax contributions. Because of this, all money you inherit from a Roth is free of income tax. You don't need to worry about paying taxes on these accounts, but you must still report the inheritance on your tax return. The inheritance may be kept by you and treated as your own retirement account if you are the spouse of the original account owner. If you are not the account owner's spouse, you must start taking distributions from the account immediately or take a lump-sum amount.
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Non-Qualified Plans
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Non-qualified retirement plans are those that fail to meet the requirements set by the Internal Revenue Service for special tax privileges found in qualified plans. An example of this would be an annuity. Annuities are insurance policies and can accept only after-tax contributions. Because of this, when you inherit an annuity, you are taxed only on the investment gain in the contract. The contributions to the annuity have already been taxed.
Pensions
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Pension plans may provide death benefit options if your spouse chose a reduced-benefit option. At your spouse's death, you can take a lump-sum pension or pension payments. Either way, you'll pay income tax on all of the amount you receive. This money is taxed as ordinary income.
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