Author Topic: Inheritance question - Tax liability on 401k  (Read 1084 times)

gardenstash

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Inheritance question - Tax liability on 401k
« on: August 24, 2020, 09:25:40 AM »
So I've posted before about an inheritance I'm receiving and it looks like I'm nearing a settlement with the other beneficiaries and will be receiving this inheritance soon.

A significant portion is coming from a 401k. It is my understanding that I will owe income tax on what I receive but because I'm receiving this as a beneficiary, I can avoid paying a 10% early withdrawal penalty even though I'm not of retirement age when I take a lump sum.

It is my intention to ultimately use this for funding my own retirement investment, probably by rolling this over into an IRA, but I need to be able to pay the tax bill on this from a portion of what I receive. I've talked to an accountant about this but I'm not sure they're giving me the right info and I don't know who else to ask. I tried talking to Fidelity but they wouldn't answer tax questions about this.

It is my understanding that the law changed in 2020 that I have to pay income taxes on this within 10 years, I can't wait until I reach retirement age myself. I'd rather take 1/10th out each year over 10 years so I'm not getting hit with one big tax bill. But would I get hit with a 10% penalty for early withdrawal if I did this, if I don't take it all out at once? That's the part I'm not clear on. Would it better to take all $300,000 in one lump sum and pay the taxes this year under what are probably lower taxes under Trump? There's a lot I don't know about this and I want to make the best educated decision on receiving this money I can to decrease my tax liability. If it matters, my income has gone way down this year due to COVID19 related work slow down, and my income will likely bounce back up next year to where it normally is.

joe189man

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Re: Inheritance question - Tax liability on 401k
« Reply #1 on: August 24, 2020, 10:03:57 AM »
find a high net worth tax accountant that works for individuals, they can help you

Ants

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Re: Inheritance question - Tax liability on 401k
« Reply #2 on: August 24, 2020, 10:39:47 AM »
I inherited an IRA in 2017 and it was pretty straight forward. Simply transfer the account to who ever holds your investments and they will hold the account as an inherited IRA. Non-spouses have to take RMDs based on the age of the deceased and those are treated as taxable income. My IRA was tiny but I invest it according to my IPS and take out $300 bucks a year. It's pretty easy but then again I don't know about any tax law changes. If this is a significant amount you probably should talk to an accountant.

tennisray

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Re: Inheritance question - Tax liability on 401k
« Reply #3 on: August 24, 2020, 11:37:02 AM »
you are correct, the tax laws changed.  My wife, who inherited an IRA in 2011 was able to space out RMDs based on her life expectancy, so she only has to take small RMDs.  For anyone inheriting one now (besides spouse, i believe), you have to draw down.  But you will NOT pay a 10% early withdrawal on these.  Just regular income tax. 

If you are close to retirement, you can wait until you retire so you can take the tax hit when you don't have an income.  If not, your plan is sound. 

gardenstash

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Re: Inheritance question - Tax liability on 401k
« Reply #4 on: August 25, 2020, 12:19:29 PM »
you are correct, the tax laws changed.  My wife, who inherited an IRA in 2011 was able to space out RMDs based on her life expectancy, so she only has to take small RMDs.  For anyone inheriting one now (besides spouse, i believe), you have to draw down.  But you will NOT pay a 10% early withdrawal on these.  Just regular income tax. 

If you are close to retirement, you can wait until you retire so you can take the tax hit when you don't have an income.  If not, your plan is sound.

Thanks, that's helpful. I was able to talk to Vanguard because I'd like to ultimately move it there and they said the same thing. I'm not close to retirement. I also enjoy working so I don't really plan on retiring for a while.

Catbert

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Re: Inheritance question - Tax liability on 401k
« Reply #5 on: September 06, 2020, 01:45:19 PM »
You won't owe a penalty unless you don't take it all out within the 10 year window.
The following thoughts assume that you'll be working the next 10 years AND that you income will stay the same or increase a bit.

What does 30K extra a year do to your tax bracket?  If you would stay within a bracket, then I would take out 30K, plus whatever additional amount you can to fill that bracket.
For this year I'd take out at least 30K, more if its still less than you usually make, and then fill the bracket. 

Are you already completely using all 401k/IRA/TSP/403b/etc available to you.  If not, do so. 

seattlecyclone

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Re: Inheritance question - Tax liability on 401k
« Reply #6 on: September 06, 2020, 03:17:07 PM »
A significant portion is coming from a 401k. It is my understanding that I will owe income tax on what I receive but because I'm receiving this as a beneficiary, I can avoid paying a 10% early withdrawal penalty even though I'm not of retirement age when I take a lump sum.

Correct. You'll owe income tax but no early withdrawal penalty on the amount you take out. Under the new laws you can take this money out over a ten-year period. Try to withdraw up to the top of your current tax bracket each year until the money is fully distributed.

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It is my intention to ultimately use this for funding my own retirement investment, probably by rolling this over into an IRA, but I need to be able to pay the tax bill on this from a portion of what I receive.

You can't roll these funds into a retirement account in your own name unless the inheritance came from your spouse. However if you weren't maxing out your annual contributions before, now you can get $30k closer each year.

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Would it better to take all $300,000 in one lump sum and pay the taxes this year under what are probably lower taxes under Trump?

I wouldn't bet on Democrats raising taxes for middle-class income levels, but your crystal ball is as good as mine.

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There's a lot I don't know about this and I want to make the best educated decision on receiving this money I can to decrease my tax liability. If it matters, my income has gone way down this year due to COVID19 related work slow down, and my income will likely bounce back up next year to where it normally is.

Yes, this does matter. If you expect your income to be lower this year than in future years, you might consider withdrawing a bigger chunk of it this year. Definitely fill up your current, lower tax bracket, and even consider withdrawing up into whatever bracket you expect to be in next year. That will reduce the risk of needing to withdraw in the next bracket above that in future years.

MDM

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Re: Inheritance question - Tax liability on 401k
« Reply #7 on: September 06, 2020, 05:59:22 PM »
If you expect your income to be lower this year than in future years, you might consider withdrawing a bigger chunk of it this year. Definitely fill up your current, lower tax bracket, and even consider withdrawing up into whatever bracket you expect to be in next year. That will reduce the risk of needing to withdraw in the next bracket above that in future years.
+1, particularly to this but also the other suggestions.

gardenstash, unless you are near some cliff/phaseout/etc., the only significant difference in the current tax code for you is probably the boundary between the 12% and 22% brackets.

For this year, do you have a guess at the marginal rates you will pay on traditional withdrawals between , say, $30K and $100K?

MustacheAndaHalf

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Re: Inheritance question - Tax liability on 401k
« Reply #8 on: September 06, 2020, 10:05:25 PM »
There's a big tax advantage to spreading the withdrawals out over a longer time frame.

A $300k lump sum is taxed in the 35% bracket for single filers.
Turn that into $150k for 2 years, and it tops out at the 24% bracket.
https://www.bankrate.com/finance/taxes/tax-brackets.aspx

Catbert

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Re: Inheritance question - Tax liability on 401k
« Reply #9 on: September 07, 2020, 01:43:40 PM »
I'll also add that you'll need to reassess the withdrawal amount every year to account for gains in the IRA.  For example, If you have 300K, withdraw 30K and it gains 9K you'll need to withdraw 31K the following year to keep on track.

Also make sure you understand when the 10 years ends.  For example, if your relative died this year, does 2020 count as year 1?  (I think it doesn't, but not sure.)  Does year 10 end on relatives date of death or end of that tax year?  (I think end of tax year, but that's just a logical guess.)

SeattleCPA

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Re: Inheritance question - Tax liability on 401k
« Reply #10 on: September 07, 2020, 10:28:54 PM »
Agree with advice to slowly drain the IRA rollover balance over ten years to "use up" lower tax brackets...

This longer blog post goes into painful detail: https://evergreensmallbusiness.com/right-way-to-handle-inherited-ira-accounts/

secondcor521

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Re: Inheritance question - Tax liability on 401k
« Reply #11 on: September 07, 2020, 11:23:24 PM »
Also make sure you understand when the 10 years ends.  For example, if your relative died this year, does 2020 count as year 1?  (I think it doesn't, but not sure.)  Does year 10 end on relatives date of death or end of that tax year?  (I think end of tax year, but that's just a logical guess.)

The 10 year period ends at the end of the calendar year that contains the 10 year anniversary of death.

So if the relative died today, then 10 years from today is September 8, 2030, and so you would have until December 31, 2030 to empty the IRA.

If the relative dies early in the tax year and the beneficiary can effect the transfer into their name early enough, the above means you can actually sometimes have 11 tax years to play with.  In the above example, 2020, 21, 22, 23, 24, 25, 26, 27, 28, 29, 2030 is 11 tax years.
« Last Edit: September 07, 2020, 11:25:13 PM by secondcor521 »