Financial advisor and writer Brandon Renfro received a question from Bill, who has around $500,000 in a 403(b) account and is in the process of writing his will. Bill is unsure if the money in his 403(b) will be taxed when distributed to his chosen beneficiaries. Brandon explains that while there may be tax implications for the heirs, the funds from the 403(b) account won’t automatically be fully taxed upon receipt. The tax consequences depend on how and when the beneficiaries withdraw the money. With proper planning, Bill can help manage the potential tax burden for his heirs.
It’s crucial to understand that the beneficiaries listed on the 403(b) account will override any conflicting instructions in the will. Therefore, ensuring that beneficiary designations align with Bill’s wishes is essential to avoid unintended outcomes. If beneficiaries are not named, distribution of the 403(b) funds may involve a probate process, which can be time-consuming and public. By naming beneficiaries, Bill can help his heirs avoid probate and expedite the funds’ transfer.
Regarding tax implications for the heirs, they will only incur taxes when they withdraw the inherited funds. The two-step process involves receiving the share from the 403(b) and deciding whether to keep the money in the account, transfer it to an inherited IRA, or withdraw it outright. Taxes are only owed on withdrawn funds in the year of withdrawal. If Roth funds are included in the 403(b) inheritance, the heirs can benefit from tax-free distributions, similar to Bill’s situation. A Roth conversion may be considered to minimize the family’s overall tax liability if the heirs’ anticipated tax rate is higher than Bill’s current rate.
For comprehensive financial and estate planning guidance, consulting with a financial advisor can provide valuable insights and strategies tailored to individual circumstances.
If you have tax planning questions regarding your retirement accounts, it may be beneficial to seek assistance from a financial advisor.
When it comes to withdrawing funds from an inherited retirement account, taking out all the money at once may not be the most tax-efficient choice. This lump sum withdrawal could result in your heirs having to report the full amount as taxable income, potentially moving them into a higher tax bracket. Opting to withdraw the funds gradually over time is often a better strategy to avoid these higher tax rates. However, specific timelines must be followed by beneficiaries.
For spousal beneficiaries, the option exists to transfer the funds into their own IRA and adhere to the standard distribution guidelines. Non-spouse beneficiaries, on the other hand, are typically required to withdraw the entire amount within a 10-year period.
Exceptions to this 10-year rule apply to beneficiaries who are minors, disabled, chronically ill, or close in age to the deceased. While most non-spouse beneficiaries will need to withdraw the funds within a decade, they are not subject to the 10% early withdrawal penalty.
Inheriting funds from a tax-advantaged retirement account like a 403(b) does not automatically trigger a tax liability for heirs. The decision to withdraw money from a tax-deferred account is what initiates the tax obligation. Strategic moves such as Roth conversions can help lessen or eliminate future tax burdens for heirs.
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Brandon Renfro, CFP®, is a financial planning columnist for SmartAsset, providing insights on personal finance and tax matters. Have a question you’d like addressed? Email AskAnAdvisor@smartasset.com for a chance to have it featured in a future column.
Please be aware that Brandon is not employed by SmartAsset and is not involved in SmartAsset AMP. Compensation has been provided for this article. Some reader-submitted questions may be edited for clarity or brevity.
