Rosie T. from Springfield, MO asks: Hi Mitch, my question isn’t really investment related per se, but I recently inherited my late father’s 401(k) and am kind of frozen as to what the next steps are. Everything I find on the internet is pretty confusing. Any tips or insight you could offer would be appreciated.
Mitch’s Response:
Thank you for writing, Rosie, and sorry for your recent loss. It’s interesting you pose this question now, because the rules have recently changed with regards to inherited IRAs, and later this year we may see even more adjustments to the final rules.1
The origins of the recent changes to inherited IRAs come from the 2019 Secure Act. In that law, Congress issued a rule that inherited IRAs must be withdrawn fully by beneficiaries over a 10-year period. Prior to the 2019 rule change, beneficiaries could spread distributions out over their entire lifetimes, so this change was significant.
But there was – and still is – confusion over how and when these distributions need to be made. Many CPAs interpreted the IRS rule as saying that heirs could wait until year 10 before making any distributions, but in May 2021 the IRS issued an update stating that heirs would also need to adhere to RMD rules if the deceased had reached RMD age when passing. In short, even tax professionals were confused.
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To make it super simple for you, I think the key detail to know is that you have 10 years to withdraw all of the funds in the inherited 401(k). That’s sort of the bottom line here, and how much you can or should take out each year will be clarified later this year by the IRS. So keep an eye out for those details.
The second key item you should know is that IRA/401(k) distributions are taxable as ordinary income, so be sure to factor that into your annual tax planning. Your tax bill may be higher this year than it was last year because of these 401(k) distributions, so it could make sense to speak with a tax professional to prepare for the impact.
Finally, with regard to how you should invest the inherited 401(k), I think it is important to remember that your investment goals are likely much different than your father’s investment goals were when he passed. Having different goals often means a different asset allocation would be appropriate for you, so keep in mind that you do not have to leave the investments in the 401(k) as they are – you can customize the asset allocation based on your goals and needs.
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