CFP® Professional Katelyn Murray breaks down which financial accounts are the best for inheritances… and which types aren’t.
When it comes to financial planning for federal government employees and retirees, considering the types of accounts to inherit is a crucial aspect often overlooked. The impact of inheriting certain accounts can significantly affect the financial wellbeing of beneficiaries, whether they are spouses or non-spousal heirs. In this guide, we’ll explore the best and worst types of accounts to inherit for federal employees and retirees.
Getting a Health Savings Account (HSA) is by far the worst thing that can happen to someone who is not married. HSAs are often applauded — and rightly so– for offering triple-tax benefits to their owners. The federal government can put money into an HSA before taxes are taken out. The funds can then grow tax-free, and any distributions from an HSA for qualified health expenses are tax-free as well. If utilized correctly, then, one may never have to pay taxes on contributions and growth in an HSA. When it comes to financial planning, the HSA is like a unicorn because investors usually have to pick between taking a tax deduction up front and paying income tax on future withdrawals from a Traditional IRA OR paying taxes up front in exchange for future tax-free withdrawals from a Roth IRA. It’s not hard to see the benefits provided by HSAs to their original owners; however, this “dream” account can turn into a nightmare for non-spouse beneficiaries inheriting the funds.
It’s important that we make the distinction between spousal beneficiaries and non-spousal beneficiaries in this case. If a spouse inherits an HSA, the spouse becomes the new account owner, and the transfer of ownership is not taxable. The funds can stay invested and growing tax-free, and distributions from the HSA will continue to be tax-free, provided that they are used for qualified medical expenses. No RMDs are required either. When a spouse inherits an HSA, it is as though they were always the owner of said account.
Roth IRAs stand out as the best type of account to inherit due to their tax-free growth and distributions. Although the IRS still requires Required Minimum Distributions (RMDs) to be taken from Roth IRAs inherited by non-spouse beneficiaries and the account must still be zeroed out within 10 years of the original owner’s date of death, beneficiaries need not worry about any impact to their taxable income, since these funds are tax-free.
While not as advantageous as Roth IRAs, brokerage accounts are still attractive inheritance vehicles inherit due to the automatic set up in cost basis as of the original owner’s date of death that is provided under current tax law. If the original owner’s cost basis (i.e., the amount of total lifetime principal they saved to the IRA) is $600,000, and the IRA is valued at $1,100,000 on the date of their death, the beneficiary who inherits the account will receive a “step-up” in cost basis to the $1,100,000 value. This means that, in theory, the beneficiary could then fully liquidate the account and have no tax implications (not that that would be advisable in most cases). Brokerage accounts also do not carry any RMD requirements or imposed timeline for total liquidation as is the case with retirement accounts.
Federal government employees and retirees should carefully consider the implications of inheriting different types of accounts and take these issues into consideration when doing their estate planning. While some accounts offer tax-efficient benefits for beneficiaries, others may lead to significant tax liabilities and complexities. Proper estate planning and strategic beneficiary designations can help mitigate these challenges, ensuring a smoother inheritance process for your loved ones.
**Written by Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **
****The Thrift Savings Plan (TSP) is a retirement savings and investment plan for Federal employees and members of the uniformed services, including the Ready Reserve. The TSP is a defined contribution plan, meaning that the retirement income you receive from your TSP account will depend on how much you (and your agency or service, if you’re eligible to receive agency or service contributions) put into your account during your working years and the earnings accumulated over that time. The Federal Retirement Thrift Investment Board (FRTIB) administers the TSP.****
The Surprising Truth About Inherited Retirement Accounts
Inheriting money is usually a good thing, right? You get a windfall that can help pay off debts or maybe splurge on something special. But when it comes to inheriting retirement accounts things get complicated fast. If you’ve been wondering whether it’s better to inherit a Roth or Traditional IRA, you’re asking a smart question that could save your beneficiaries thousands in taxes.
Most of the time, giving your kids a Roth IRA is the best thing you can do. But why? What are the rules? Let’s make it easy to understand.
The Big Difference: Taxes Now or Taxes Later
Before diving into inheritance rules, let’s quickly understand the basic difference:
- Traditional IRA: Contributions are tax-deductible (meaning you don’t pay taxes on the money you put in), but withdrawals during retirement are taxed as income.
- Roth IRA: Contributions are made with after-tax dollars (you’ve already paid taxes on this money), but qualified withdrawals in retirement are completely tax-free.
This fundamental difference carries over to inheritance situations and makes a huge impact on your beneficiaries
What Happens When Someone Inherits Your IRA?
When someone inherits your IRA, they have several options depending on their relationship to you and the type of IRA. The rules changed significantly when the SECURE Act passed in 2019, so it’s important to understand the current landscape.
The 10-Year Rule: A Game Changer
For most non-spouse beneficiaries (like your children) who inherit IRAs after 2019, the “stretch IRA” provision is gone. Instead, they now face what’s called the “10-year rule,” which requires them to empty the inherited IRA within 10 years of the original owner’s death.
This is where the type of IRA makes a HUGE difference!
Inheriting a Traditional IRA: The Tax Burden
When someone inherits your Traditional IRA, here’s what they face:
- They must pay income taxes on ALL distributions they take.
- These distributions could push them into higher tax brackets during their prime earning years.
- They can’t retitle the account in their name (unless they’re your spouse).
- They must empty the account within 10 years (with some exceptions).
There is a tax and estate expert at TIAA called Jonathan Fishburn who says, “Many of the people who inherit IRAs are adult children in their 50s.” They’re in their prime earning years. In other words, making them take all of the benefits over the next 10 years means they have to pay the highest possible taxes. “.
That’s a big tax hit during years when they’re likely already in higher tax brackets!
Inheriting a Roth IRA: The Clear Winner
When someone inherits your Roth IRA:
- Distributions are completely TAX-FREE (provided the account was open for at least 5 years).
- They still must empty the account within 10 years, but without tax consequences.
- The money can continue growing tax-free during those 10 years.
- They have flexibility about when to take distributions within the 10-year period.
In general, this is better because your heirs get all the money and don’t have to pay any taxes on it.
Special Rules for Spouses
If you’re married, your spouse has more options regardless of which type of IRA they inherit:
For Traditional IRAs, spouses can:
- Designate themselves as the account owner (retitle the account)
- Roll over the inherited funds into their own IRA
- Treat it as a beneficiary IRA with different RMD rules
For Roth IRAs, spouses can:
- Take the money tax-free (if the 5-year rule is satisfied)
- Transfer the assets to their own Roth IRA
- Let the money grow indefinitely without RMDs
Spouses have the most flexibility with either type of account, but the Roth still has the edge because of its tax-free nature.
Let’s Compare Scenarios
Imagine two siblings, Alex and Sam, who each inherit $500,000 from their parents. Alex inherits a Traditional IRA while Sam inherits a Roth IRA.
Alex (Traditional IRA):
- Must take $500,000 in distributions within 10 years
- Will pay income tax on each distribution
- If in the 24% tax bracket, will lose approximately $120,000 to taxes
- Nets approximately $380,000 after taxes
Sam (Roth IRA):
- Must also take $500,000 in distributions within 10 years
- Pays ZERO taxes on distributions
- Nets the full $500,000
That’s a $120,000 difference! And this doesn’t even account for the additional growth during those 10 years, which would also be taxable for Alex but tax-free for Sam.
The 10-Year Rule: Important Details
Let’s clarify how the 10-year rule works:
- The clock starts on December 31 of the year following the original owner’s death
- For most non-spouse beneficiaries, all funds must be withdrawn by the end of the 10th year
- You don’t have to take money out each year – you could wait and take it all in year 10 if that makes sense tax-wise
- However, according to IRS rules issued in July 2024, non-spouse beneficiaries inheriting from someone in RMD payout status must take annual distributions rather than distributing the funds as they choose
Exceptions to the 10-Year Rule
Not everyone has to follow the 10-year rule. “Eligible designated beneficiaries” include:
- Surviving spouses
- Minor children (until they reach majority age)
- Disabled individuals
- Chronically ill individuals
- Beneficiaries not more than 10 years younger than the deceased
These individuals can generally stretch distributions over their lifetime instead of being limited to the 10-year window.
Steps to Take When You Inherit an IRA
If you inherit an IRA, here’s what to do:
- Don’t rush decisions. You have time to figure out the best approach.
- Set up an inherited IRA in your name. You’ll need the death certificate and account information.
- Understand the tax implications. For Traditional IRAs, plan for the tax impact of distributions.
- Consider timing. If inheriting a Traditional IRA, plan distributions around your income to minimize tax impact.
- Get professional advice. The rules are complex and mistakes can be costly.
Smart Strategies for Beneficiaries
If you inherit a Traditional IRA, consider these strategies:
- Take larger distributions in years when your income is lower
- Spread distributions out to avoid jumping into higher tax brackets
- Consider taking distributions before retiring if you expect lower income then
If you inherit a Roth IRA:
- Let the money grow as long as possible within the 10-year period
- Take advantage of the tax-free growth for the full decade
- Consider larger distributions during market highs
So Which Is Better To Inherit?
Most of the time, inheriting a Roth IRA is better than inheriting a Traditional IRA when you look at the numbers and the tax consequences. The primary advantages are:
- Tax-free distributions – This is the biggest benefit by far
- No tax bracket concerns – Distributions won’t push beneficiaries into higher tax brackets
- More net inheritance – Heirs keep 100% of what they inherit, not 70-80% after taxes
- Flexible timing – Can time distributions optimally without tax concerns
What This Means for Your Estate Planning
If you’re still in the accumulation phase and deciding between Traditional and Roth IRAs for yourself, consider the inheritance angle. While Traditional IRAs might save you taxes now, converting to a Roth could be one of the most generous things you do for your heirs.
Some considerations:
- Roth conversions: Consider converting Traditional IRA assets to Roth over time, especially in years when your income is lower.
- Pay taxes now: Remember that you’re essentially paying the tax bill now so your heirs don’t have to later.
- Balance your needs: Don’t sacrifice your own retirement security just to leave a tax-free inheritance.
Common Questions About Inherited IRAs
Can I combine an inherited IRA with my own?
No, you cannot combine an inherited IRA with your existing IRAs unless you are the spouse of the deceased. Non-spouse beneficiaries must keep inherited IRAs separate.
What happens if I miss taking RMDs from an inherited IRA?
If you fail to take required distributions, you could face a penalty tax of 25% on the amount that should have been withdrawn.
Can I contribute to an inherited IRA?
No, you cannot make additional contributions to an inherited IRA regardless of whether it’s a Traditional or Roth account.
What if there are multiple beneficiaries?
Each beneficiary should set up their own inherited IRA with their portion of the funds to maintain maximum flexibility.
Wrapping Up: The Clear Advantage of Roth IRAs
In the battle between inheriting a Traditional vs. Roth IRA, the Roth IRA wins hands down for most beneficiaries. The ability to receive completely tax-free distributions gives the Roth a massive advantage that’s hard to beat.
For those planning their estates, converting Traditional IRA assets to Roth during your lifetime—especially during lower-income years or periods of market downturns—can be a tremendous gift to your heirs. Yes, you’ll pay some taxes now, but you’ll potentially save your beneficiaries from much larger tax bills later.
Remember that tax laws are always changing, so it’s important to work with knowledgeable financial advisors and tax professionals who can help you navigate these complex rules and make the best decisions for your specific situation.
Have you inherited an IRA or are you planning your estate? I’d love to hear your experiences in the comments below!
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For a non-spouse beneficiary, though, it’s a very different story. In the event that an HSA passes to a non-spouse beneficiary, the HSA immediately ceases to be an HSA, is fully liquidated, and is distributed to the non-spouse beneficiary. The fair market value of the account assets as of the date of the account holder’s death is includible in the non-spouse beneficiary’s taxable income for the current tax year as well, likely resulting in a large portion of the account’s assets going to cover the taxes due on the mandated lump sum distribution. This problem can be particularly devastating if 1) your beneficiary is already in a pretty high tax bracket and/or 2) if you have a rather large HSA balance that could bump your beneficiary into a higher tax bracket if/when the HSA is paid out to them a lump sum. (If the beneficiary is the deceased account holder’s estate, this amount is includible in the decedent’s gross income for the year in which the death occurred. ) For this reason, we recommend immediately beginning to use your HSA in retirement for any and all qualified medical expenses — ideally, you want to spend this money down before you pass away so that your beneficiaries don’t have to deal with this tax bomb.
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Out of State Real Estate Property
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TSP Funds (Thrift Savings Plan)
Remember that the TSP is the largest employer retirement plan in the world, and, as such, service isn’t very personalized or fast. That said, the process of a spousal beneficiary inheriting a TSP is fairly straightforward. When a spouse inherits a TSP, the funds are simply rolled into an inherited TSP account for the benefit of the spouse, and they can continue to use the funds as though they were the original account owner. No RMDs are required.
The issue comes up when the surviving spouse dies and the TSP funds are given to that person’s beneficiary. In most cases, these are the children of the original account owner and the now-deceased spouse. These “second-generation” beneficiaries are NOT offered the option to roll the inherited funds into an inherited TSP account. Instead, the TSP balance is emptied out completely, and the beneficiary is forced to take a lump sum distribution. This means that, for pre-tax or Traditional TSP funds, the distribution is fully taxed at the beneficiary’s income tax rate, which includes the TSP distribution. From a tax perspective, this can result in substantial tax liabilities for beneficiaries.
Traditional IRAs are not the worst possible inheritance vehicles, but they aren’t terribly tax-efficient when inherited by non-spouse beneficiaries. As is the case with TSPs, spouses can inherit with no RMDs imposed. It is important to remember that every dollar distributed from a Traditional IRA is taxed at your beneficiary’s income tax rate; however, and that your death may likely result in your spouse being pushed into a higher tax bracket due to the different in income brackets between Married Filing Jointly filers and Single filers. This could mean that there’s actually less net funds available for your spouse in your Traditional IRA than you think.
The picture gets even less rosy for non-spouse beneficiaries. These folks are subject to the “10-year rule” imposed by The Secure Act of 2020, further revised by The Secure Act 2. 0 of 2022. According to this rule, not only are non-spousal beneficiaries forced to take RMDs from Inherited IRA balances starting the year after the original account owner’s death, they also must fully distribute all assets in the Inherited IRA, regardless of size, within 10 years from the date of the original owner’s death. For beneficiaries who are already in a high tax bracket due to their own income, these RMDs and the mandate to drain the account within 10 years can result in them being kicked up into a higher tax bracket, with the end result being that more of the inherited funds end up going to cover taxes owed. In cases where folks have multiple children in different tax brackets, you may consider leaving pre-tax assets like Traditional IRAs to those in a lower tax bracket, and tax-advantaged accounts like Roth IRAs and brokerage accounts to those in a higher tax bracket, keeping in mind that you’ll need to account for the taxes owed on pre-tax accounts if the goal is to have assets distributed evenly between kids.
Because they grow and give out money tax-free, Roth IRAs are the best type of account to inherit. Required Minimum Distributions (RMDs) must still be taken from Roth IRAs that are inherited by non-spouse beneficiaries, and the account must still be emptied within 10 years of the date of death of the original owner. However, beneficiaries don’t have to worry about how these funds will affect their taxable income because they are not taxed.
While not as advantageous as Roth IRAs, brokerage accounts are still attractive inheritance vehicles inherit due to the automatic set up in cost basis as of the original owner’s date of death that is provided under current tax law. If the original owner’s cost basis (i.e., the amount of total lifetime principal they saved to the IRA) is $600,000, and the IRA is valued at $1,100,000 on the date of their death, the beneficiary who inherits the account will receive a “step-up” in cost basis to the $1,100,000 value. This means that, in theory, the beneficiary could then fully liquidate the account and have no tax implications (not that that would be advisable in most cases). Brokerage accounts also do not carry any RMD requirements or imposed timeline for total liquidation as is the case with retirement accounts.
Federal government employees and retirees should carefully consider the implications of inheriting different types of accounts and take these issues into consideration when doing their estate planning. While some accounts offer tax-efficient benefits for beneficiaries, others may lead to significant tax liabilities and complexities. Proper estate planning and strategic beneficiary designations can help mitigate these challenges, ensuring a smoother inheritance process for your loved ones.
**Written by Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **
****The Thrift Savings Plan (TSP) is a retirement savings and investment plan for Federal employees and members of the uniformed services, including the Ready Reserve. The TSP is a defined contribution plan, meaning that the retirement income you receive from your TSP account will depend on how much you (and your agency or service, if you’re eligible to receive agency or service contributions) put into your account during your working years and the earnings accumulated over that time. The Federal Retirement Thrift Investment Board (FRTIB) administers the TSP.****