When a loved one passes away, their invested assets often become a significant part of the legacy they leave behind. These assets—ranging from retirement accounts to trusts and investment portfolios—each follow different rules for distribution. Whether you’re planning your own estate or preparing to inherit, understanding how these assets are passed on, and the tax implications involved, is critical to protecting your family’s financial future.
401(k) Accounts (Tax-Deferred Contributions)
When a 401(k) account is passed down to a non-spouse beneficiary, there are generally two main options for how the assets can be received: as a lump sum distribution or through a rollover into an inherited IRA. (In some cases, the beneficiary can do portions of each).
Choosing a lump sum means the entire 401(k) balance is paid out at once and treated as ordinary income in the year it’s received—potentially pushing the beneficiary into a much higher tax bracket. If the client is aged 64 or older, it's essential to consider the impact of increased income on their Medicare premiums. The Income-Related Monthly Adjustment Amount (IRMAA) could be affected, leading to higher premiums for Medicare Part B and Part D.
Alternatively, non-spouse beneficiaries can opt to roll the 401(k) into an inherited IRA and avoid immediate taxation. Under the SECURE Act, most non-spouse beneficiaries must withdraw the entire balance from an inherited IRA within 10 years, though this option provides more time and flexibility for managing taxes and investment growth.
However, spousal beneficiaries have an additional advantage—they can roll the inherited 401(k) into their own IRA or workplace retirement plan, treating it as their own account. This strategy allows them to delay required minimum distributions (RMDs) and avoids the 10-year rule entirely, preserving the tax-deferred status of the funds for longer. In addition to a rollover, spouses have the option to liquidate all holdings within the account (“lump sum”) and pay taxes or do portions of each (partial liquidation and a partial rollover). In some instances, the funds might be allowed to remain in the deceased spouse’s 401(k) plan.
How They’re Inherited:
- 401(k) accounts are transferred based on the beneficiary designation form on file with the plan administrator—this form takes precedence over any will or trust.
- If no beneficiary is listed, the account usually becomes part of the estate, potentially triggering probate and delaying distribution.
Rules for Beneficiaries:
- Under the SECURE Act, most non-spouse beneficiaries must withdraw the full balance within 10 years.
- Non-spouses cannot roll the account into their own retirement plan but must transfer it into an inherited account.
- Spouses may roll the 401(k) into their own IRA and treat it as their own, avoiding the 10-year rule.
Tax Considerations:
- Inherited 401(k) withdrawals are taxed as ordinary income.
- Spreading withdrawals over the 10-year period may reduce the overall tax burden.
Traditional IRAs (Tax-Deferred Contributions)
Traditional IRAs function in a similar way to 401(k)s when passed down to beneficiaries, especially when it comes to taxation and distribution options. Like a 401(k), a traditional IRA can be transferred to an inherited IRA, allowing non-spouse beneficiaries to stretch withdrawals over a 10-year period under the SECURE Act—though they cannot contribute to or combine it with their own IRA. A lump sum distribution is also an option, and in that case, the entire amount is taxed as ordinary income in the year it’s received.
Spouse beneficiaries again have more flexibility—they can either treat the account as an inherited IRA (subject to the 10-year rule) or roll it into their own traditional IRA. By rolling it into their own IRA, they can delay required minimum distributions (RMDs) until they reach the age of 73, based on the new SECURE 2.0 Act starting in 2023, and take withdrawals based on their own life expectancy. In both account types, it’s important to note that the original owner’s beneficiary designations override any instructions in a will, making it essential to keep these designations up to date.
How They’re Inherited:
- Like 401(k)s, traditional IRAs pass based on the beneficiary designation.
- If no beneficiary is named, the IRA passes through the estate.
Rules for Beneficiaries:
- Non-spouse beneficiaries must deplete the account within 10 years.
- Spouses can roll the inherited IRA into their own, allowing them to delay Required Minimum Distributions (RMDs) until age 73 (starting in 2023 under SECURE 2.0)
Tax Considerations:
- Distributions are taxed as ordinary income.
- Strategic timing of withdrawals can minimize taxes.
Roth IRAs (After-Tax Contributions)
Roth IRAs, funded with after-tax contributions, offer a uniquely beneficial structure for beneficiaries—particularly when it comes to taxes. Like traditional IRAs, Roth IRAs are passed to heirs based on the beneficiary designation form, not the will or trust. For non-spouse beneficiaries, the inherited Roth IRA must be fully distributed within 10 years of the original owner’s death, but unlike traditional accounts, these distributions are generally tax-free as long as the account has been open for at least five years. This makes Roth IRAs a powerful estate planning tool, as they can provide tax-free income to heirs during the withdrawal period.
Spouse beneficiaries can treat the Roth IRA as their own, allowing them to continue tax-free growth and delay required minimum distributions altogether. Because of their favorable tax treatment, Roth accounts are often strategically used to pass on wealth in a more tax-efficient manner.
How They’re Inherited:
- Passed via beneficiary form, not a will or trust.
- Roth IRAs are funded with after-tax dollars, so distributions are generally tax-free if the account has been open for at least five years
Rules for Beneficiaries:
- Non-spouse beneficiaries must still withdraw all funds within 10 years but owe no taxes on qualified withdrawals.
- Spouses can treat the Roth IRA as their own, with no RMDs during their lifetime.
Tax Considerations:
- Inherited Roth IRAs offer a tax-free income stream—making them a powerful legacy tool.
Individual (Taxable) Investment Accounts
Unlike retirement accounts, individual (or joint) taxable investment accounts are generally passed through a will, trust, or in accordance with state intestacy laws if no estate plan is in place. These accounts do not require a beneficiary designation form, although some custodians allow for transfer-on-death (TOD) instructions to streamline the process.
While the majority of states in the U.S. allow TOD accounts, there are two states that do not permit this designation. These states usually have alternative methods for transferring assets upon death, but they often require probate or other legal procedures that can be more complex and costly.
Texas
Texas has specific provisions when it comes to TOD accounts. While it allows TOD designations for securities under the Texas Uniform Transfer on Death Security Registration Act, it does not permit TOD designations for real estate. This means that individuals in Texas cannot use TOD deeds for property, necessitating alternative estate planning methods such as wills or trusts for real estate assets.
Louisiana
Louisiana only recently has begun to allow TOD accounts. The state's estate laws are deeply rooted in its civil law tradition, which differs significantly from the common law traditions followed by most other states. However, not all custodians have adopted their policies and procedures to allow for this change in the law.
Step-Up Advantage
One major advantage of inheriting taxable investment accounts is the “step-up” in cost basis. When the original owner passes away, the cost basis of the investments is adjusted to their fair market value at the date of death. This can significantly reduce or even eliminate capital gains taxes for the beneficiary if they choose to sell the investments shortly after inheritance.
For example, if a parent purchased a stock for $10,000 and it’s worth $25,000 at death, the child inherits it with a $25,000 cost basis—resulting in no taxable gain if sold at that price.
How They’re Inherited:
- Transfer-on-death (TOD) accounts can pass to stated beneficiaries automatically upon the account holder’s death.
- Accounts can transfer through a will, trust, or state intestacy laws if no estate plan exists.
- They are usually not governed by a beneficiary designation form.
Tax Considerations:
- Beneficiaries benefit from a “step-up” in cost basis—resetting the asset’s value to the market price at the date of death.
- This can significantly reduce capital gains taxes when selling inherited investments.
Example:
- If your loved one bought a stock at $10,000 and it’s worth $20,000 when they pass, your cost basis resets to $20,000. You only owe capital gains taxes on any growth above that amount if you sell.
Trusts
Trusts are commonly used in estate planning to provide greater control over how and when assets are distributed to beneficiaries. A trust can hold various asset types, including cash, investments, and real estate. Assets held in a revocable living trust avoid probate and are distributed according to the terms laid out in the trust document. Upon the grantor’s death, the trust becomes irrevocable, and the trustee must follow the specified instructions for managing and distributing the trust’s assets.
Irrevocable trusts created during a person’s lifetime also serve as estate planning tools for tax mitigation and asset protection. However, trusts are subject to compressed income tax brackets, meaning undistributed income may be taxed at higher rates than if received directly by a beneficiary
That said, when income is distributed to beneficiaries, it is typically taxed at the recipient’s personal tax rate. Trusts can be especially valuable when planning for minors, individuals with disabilities, or beneficiaries who may not be financially responsible.
How They’re Inherited:
- Trusts can hold a wide range of assets and distribute them according to detailed instructions.
- Revocable Living Trusts: Allow assets to pass outside probate while remaining under the owner’s control during life.
- Irrevocable Trusts: Permanently transfer assets out of the grantor’s estate, often used for tax or asset protection planning.
Tax Considerations:
- Trust income retained within the trust is taxed at high trust tax rates.
- Income distributed to beneficiaries is taxed at the recipient’s individual rate.
- Trusts can provide structure and protection but require careful planning to avoid unintended tax consequences.
CAN AN INHERITED IRA BE COMBINED WITH AN EXISTING IRA?
- No. Inherited IRAs must remain separate.
- However, spouses can roll inherited assets into their own IRA, gaining more flexibility and avoiding early RMDs (or any RMDs in a Roth IRA).
KEY ESTATE PLANNING TIPS
- Keep Beneficiary Forms Updated: They override wills. Update after marriage, divorce, births, or deaths.
- Understand the SECURE Act: Most non-spouse heirs must withdraw inherited retirement funds within 10 years.
- Use Tax Strategies: Strategic withdrawals and Roth conversions can reduce future tax liabilities.
- Consider a Trust: Especially if you have minor children, beneficiaries with special needs, or want to control timing of distributions.
- Communicate Your Plan: Let your family know your wishes and where important documents are kept.
Conclusion
Inheriting invested assets may come with emotional weight and financial complexity. With proactive estate planning and a clear understanding of how each type of account is treated, you can help preserve your legacy, aim to reduce potential tax burdens, and support a smoother transition for your loved ones.
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Disclosures
Each 401K plan has its own specific rules regarding beneficiary designations, distribution options, and taxes, so it’s critical to review the plan documents.
TruWealth Advisors, LLC is an SEC registered investment adviser located in Louisiana. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own tax, legal and financial professionals before engaging in any transaction. Past performance does not guarantee future results. Additional information about TruWealth Advisors, including our registration status, fees, and services is available on the SEC’s website at https://adviserinfo.sec.gov/firm/summary/306876.