How is the required amount calculated?

Inheriting an IRA or 401(k) can add wealth, but it can also bring some potential tax headaches. A difficult issue involves required minimum distributions, or RMDs. Owners of IRA and 401(k) plans are required to take minimum distributions from their accounts beginning in the year they turn 72. The IRS has special rules regarding RMDs in the year of death that IRA and 401(k) beneficiaries should be aware of. A financial advisor can walk you through the ins and outs of retirement planning to put your mind at ease.

When do RMDs start?

Under the tax code, certain retirement account owners must begin taking minimum distributions once they turn 72. The types of accounts subject to RMD include:

Roth IRAs are not subject to RMDs during the lifetime of the account owner. However, you will be subject to RMDs if you inherit a Roth IRA. The IRS is very specific about when these distributions must begin. The required start date (RBD) for the RMD is April 1^St from the year following the one in which the account holder turns 72. This is important to understand when an RMD is required in the year of death.

When is an RMD required in the year of death?

If you inherit an IRA or other tax-advantaged account that is subject to RMDs, timing determines whether you must take an RMD in the year of death.

Here’s how it works:

• You must take an RMD if the account owner met the required start date but did not receive a required minimum distribution for the year.

• You don’t have to take an RMD if the account owner dies before the required start date.

Here is an example of how it works. Let’s say your father turned 72 in March 2020, and the required start date is April 1, 2021. He dies in November 2021 without taking any RMDs for that year. In this case, you will be responsible for taking the distribution as the beneficiary of the account.

Now, let’s say your father died in March 2021. Because he didn’t reach the required start date, you wouldn’t be required to take an RMD in the year of death.

When beneficiaries must take an RMD in the year the account holder dies, the amount is reported on the tax return as income. They must pay taxes on it, the same way the account owner would have had to if they had taken the distribution themselves.

How to Calculate RMD in the Year of Death

If you are required to take RMDs in the year of death after the account owner dies, the calculation method is based on the RMD they would have received. Following IRS rules, the RMD for any year is determined using this formula:

The story continues

Required Minimum Distribution = account balance at the end of the previous calendar year divided by a distribution period from the IRS Uniform Lifetime Table

The Uniform Lifetime Table is designed for unmarried IRA owners, married IRA owners whose spouses are no more than 10 years younger than them, and married owners whose spouses are not the sole beneficiaries of the IRA. Table I (Single Life Expectancy) is used when the beneficiary is not the spouse of the IRA owner. Table II (Joint Life Expectancy and Last Survivor) is used for owners whose spouses are more than 10 years younger and the sole beneficiary of the IRA.

If the account owner named multiple beneficiaries and did not take their required minimum distribution, each beneficiary shares responsibility for it. Beneficiaries can split the account into multiple inherited IRAs, which would allow them to claim their share of the account balance while shouldering their share of the tax liability.

For RMDs in the year following the account holder’s death, the distribution calculations will depend on who the account beneficiary is. Generally, designated beneficiaries will use the IRS Single Life Expectancy Table to calculate distributions. This table uses life expectancy and the IRA balance to determine the RMD.

What happens if you don’t take an RMD in the year of death?

The deadline for taking RMDs in the year of death is December 31^St from the year the original account owner dies. The IRS imposes a stiff penalty when RMDs are claimed but not taken by beneficiaries. If you inherit an IRA or 401(k) and don’t take the RMD for the year of the account owner’s death, a 50% tax penalty applies.

There is an exception if the estate is named as the beneficiary of an IRA. In this case, the estate takes the RMD and is responsible for reporting the distribution.

The 50% penalty can substantially reduce what you can withdraw from an inherited IRA or 401(k). For this reason, it is important to understand when RMDs are or are not required when the account owner dies. Talking to a tax expert or financial advisor can help you prepare for any tax liability that might be created if you want to inherit an IRA or 401(k) from someone else.

Withdrawing an Inherited IRA

The IRS year-of-death RMD rule isn’t the only tax rule to be aware of with inherited retirement accounts. You also need to be aware of the tax liability for managing the account in future years.

Spouses have several options for inheriting an IRA. For example, they can:

If you are not the account owner’s spouse, you can only set up an inherited IRA. You will not be allowed to make new contributions to the account. You must also completely withdraw all money from the account. You have 10 years from the death of the original account owner to do this. If you fail to do so, the IRS may impose a tax penalty.

In terms of how withdrawals are taxed, they follow the same tax rules as the original IRA. So if you inherit a traditional IRA, withdrawals are taxed at your ordinary income tax rate. If you inherit a Roth IRA, RMDs are required, but withdrawals are tax-free as long as the account is at least five years old. A financial advisor can help you navigate an inheritance.

conclusion

Inheriting retirement accounts can add stress to your tax situation, and it’s important to be aware of the year-of-death RMD rules. The main thing to know is when the account owner’s required start date is, as this can decide whether you will have to take an RMD in the year of death or not.

Tips for planning your retirement

• Consider talking to your financial advisor about how to manage an inherited retirement account. Finding a qualified financial advisor doesn’t have to be difficult. The free SmartAsset tool matches you with up to three financial advisors serving your area, and you can interview your matched advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

• When you roll over an inherited IRA, think about which brokerage you want to use to hold those funds. Brokerages can vary widely in the fees they charge and the range of investment options they offer. Comparing different brokerages online can help you find the best place to keep your inherited retirement funds.

• Keep an emergency fund handy in case you face unexpected expenses. An emergency fund should be liquid—in an account that isn’t exposed to significant fluctuations, such as the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.

• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with prospects and offers marketing automation solutions so you can spend more time converting. Learn more about SmartAsset AMP.

©iStock.com/dragana991, ©iStock.com/Dean Mitchell, ©iStock.com/shapecharge

The post How to Calculate RMD in Year of Death appeared first on SmartAsset Blog.