Ask an Advisor: Will the $500k in My Retirement Account Be Taxed When My Heirs Inherit it?

I have about $500,000 in a 403(b) account. I am writing my will and I do not know whether the money in my 403(b) will be subject to taxes when it is distributed to those I list in my will. Or, will the money just pass directly to those whom I have named?

– Bill

Bill, it’s great that you’re thinking about this in advance. While your heirs may face tax consequences, your 403(b) balance won’t automatically be taxed in full when they receive it. Instead, the tax implications depend on how and when they withdraw the funds. Fortunately, with careful planning, you can help manage their potential tax burden. Let’s break down how your 403(b) assets will pass to your heirs and what they should expect in terms of taxation.

If you’re facing questions about how to manage your wealth or plan your estate, consider speaking with a financial advisor.

Leaving a 403(b) to Your Heirs

Because we are talking about your retirement account and your will, there’s an important distinction to keep in mind: While your will determines how most of your assets are distributed after your death, your 403(b) account allows you to name beneficiaries directly.

This is an extremely important distinction for a couple of reasons:

1. Beneficiary Designations Override a Will

Even if your will and your 403(b) beneficiary designations conflict, the beneficiaries listed on your account will receive the funds. For example, if your will states that your 403(b) should go to your children, but your account still lists an ex-spouse as the beneficiary, your ex-spouse will inherit the funds. Be sure your beneficiary designations align with your wishes.

2. Leaving the Beneficiary Designation Blank Can Create Complications

If you don’t designate beneficiaries, your 403(b) will be distributed according to your will, which often means going through probate. Probate is a legal process that can be time-consuming and public. By naming beneficiaries on your 403(b), you can help your heirs avoid probate and receive the funds more quickly.

(But if you have additional questions about financial planning and/or estate planning, match with a financial advisor and talk it over.)

Tax Consequences of Inheriting a 403(b)

As I mentioned, there are tax consequences your heirs need to understand but they aren’t directly related to receiving the funds. Your heirs only incur a tax obligation when they withdraw the money. Think of it as a two-step process.

Step 1: Your heirs will receive their share from the 403(b). They can choose to leave the money in the account or transfer it to an inherited IRA. If they do either of these, they won’t owe any taxes immediately. If they choose to receive the money outright – such as by depositing it into their savings account – then it’s fully taxable.
Step 2: If they keep the money in the 403(b) or transfer it to an inherited IRA, they will only owe taxes on money they withdraw, in the year they withdraw it.

Keep in mind that if you live in a state that levies inheritance tax, your heirs may be subject to this additional tax, regardless of where they live.

Also, if you leave any Roth funds in your 403(b) to your heirs, they will enjoy the same tax-free distributions, just as you would have. This is a reason to consider doing a Roth conversion. If your tax rate is lower than the rate you anticipate your heirs will be in when they withdraw the money, then converting beforehand can reduce your family’s total tax liability on that money.

(But if you have additional tax planning questions related to your retirement accounts, consider working with a financial advisor.)

Distribution Rules for Inherited Retirement Accounts

Withdrawing the money all at once is normally not the best choice from a tax perspective. Doing so would require your heirs to include the full amount in their taxable income. This may push them into a higher tax bracket. Instead, it’s often better to take the money out over time to avoid higher tax brackets. However, there are certain timelines beneficiaries have to adhere to.

Spousal beneficiaries can roll the money into their own IRA and follow the standard distribution rules.
Non-spouse beneficiaries generally must withdraw all of the money within 10 years.
There are some exceptions for beneficiaries who are minors, disabled or chronically ill, or not more than 10 years younger than the deceased.

Even though most non-spouse beneficiaries will have to withdraw the money within 10 years, the 10% early withdrawal penalty does not apply to them. (If you’ve recently inherited money, consider matching with a financial advisor and making a plan for the windfall.)

Bottom Line

Inheriting money from a 403(b) or similar tax-advantaged retirement account does not create an immediate tax liability for your heirs. Instead, their decision to withdraw the money from a tax-deferred account is what triggers the tax liability. However, certain moves, like Roth conversions, can reduce or eliminate your heirs’ future tax burden.

Financial Planning Tips

A financial advisor can be a valuable resource during the financial planning process. In fact, using a proprietary model that calculates the value of the client-planner relationship, SmartAsset estimates that the typical 55-year-old could end up with 35% more money by age 77 by working with a financial advisor.
Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.

Please note that Brandon is not an employee of SmartAsset and is not a participant in SmartAsset AMP. He has been compensated for this article. Some reader-submitted questions are edited for clarity or brevity.