With the wide variety of insurance and retirement savings plans available to retirees today, there has been an increase in the types of assets that are being passed on to surviving spouses of deceased retirees. The tax implications of some of those inherited assets can be quite significant.
Typically, the owners of the insurance policies and retirement plans will designate their spouses as the primary beneficiary on the policy or retirement plan. Proceeds from life insurance policies paid to spouses as beneficiaries are tax exempt. If the retirement plan is a Roth IRA, then the original contributions and subsequent earnings in the plan are distributed tax free to the owner. Beneficiaries will assume the same tax free rights. However, retirement plans such as traditional IRAs, 401K plans, annuities, etc. are taxable when distributed to the owner of the plan. So, what happens when assets remain in these plans upon the death of the owner and remaining amounts are payable to a surviving spouse as beneficiary or co-owner?
Recent changes to the Internal Revenue Code provide several options to surviving spouses. Depending on which option the beneficiary selects, there are different tax implications. One option enables the beneficiary to designate the proceeds as their own IRA. If the retirement plan was set up with the surviving spouse as a co-owner, then the plan will continue with the surviving spouse as the new owner. Surviving spouse beneficiaries who take the first option will likewise become the owner of the plan and the tax rules apply as if the original investments were made by the beneficiary. This means that funds can be withdrawn and taxed at ordinary income tax rates, without penalties, when the new owner reaches the age of 59 1/2. Distributions MUST be taken once the owner reaches the age of 70 1/2. Otherwise, penalties will apply.
A second option available to surviving spouses is to receive a lump sum payment of the death benefit or remaining amount of the assets. This can have grave tax consequences. The lump sum amount will be subject to ordinary income taxes in the year received. By adding such amounts to the surviving spouse’s regular income may put them into a much higher tax bracket. Before electing this option, surviving spouses should consult their tax advisor.
A third option available to surviving spouses is to pass the benefit to secondary beneficiaries. This option denies the surviving spouse from receiving any of the benefits and avoids any tax consequences, currently or deferred. Ownership of the funds passes immediately to the secondary beneficiaries (e.g. children of the deceased).
Send in your questions and ideas to: Sun Day, Frugal Forum Column, P.O. Box 761, Huntley, IL 60142, or, by email to: thefrugalforum@gmail.com.
