(This article originally appeared in the June 2024 issue of Military Officer, a magazine available to all MOAA Premium and Life members. Learn more about the magazine here; learn more about joining MOAA here.)

After spending years building up your nest egg, you might be thinking further into the future and wondering how your savings can become a legacy that provides beyond your lifetime. Knowing the rules for inheriting retirement accounts — and making sure your heirs also understand those rules — can help turn those hard-earned savings into a lasting legacy.

One of the most critical steps: having a conversation with your heirs. In addition to sharing financial information, you can share your values about money or your wishes for the legacy you want to leave and the financial security you want to pass on.

With both you and your heirs on the same page, you can help ensure your nest egg continues to provide your loved ones with a secure financial foundation.

The rules for inheriting traditional and Roth individual retirement accounts (IRAs) are similar to the rules for inheriting traditional and Roth 401(k) accounts and Thrift Savings Plan (TSP) accounts; check MOAA's financial news feed in the coming days for a follow-up article featuring some rule differences between the account types.

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Here are five things you and your heirs need to know about passing on retirement accounts.

1. Naming Beneficiaries is Key

When you open a retirement account either at a financial firm or with an employer plan, one of the first items to check off your list is to name beneficiaries.

You can name primary beneficiaries and contingent beneficiaries and decide how much of a percentage each beneficiary will get. Designating beneficiaries is a key step to ensure a retirement account can live beyond your lifetime.

Note that for 401(k)s, generally a spouse must be named as a beneficiary. Otherwise, the employee must get the spouse’s consent to not be named.

2. Retirement Accounts Pass Outside the Will

While it’s important to have a will, retirement accounts actually pass outside the will to the named beneficiaries. If the heirs named in your will are different than the ones named as beneficiaries on your retirement accounts, the retirement accounts will go to the listed account beneficiaries.

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Be sure to regularly review who you have named as beneficiaries to ensure your current wishes are fulfilled. Review them at least once a year as well as when any major life event, such as a birth, death, divorce, or marriage, occurs. If you get divorced but forget to remove your ex-spouse as the beneficiary of your retirement account, the ex-spouse would receive the money at your death.

The ability for these accounts to pass outside the will provides an added bonus. “With named beneficiaries, the accounts avoid probate,” said former Sgt. Marcus Hull, USA, a financial advisor with RBC Wealth Management.

3. Different Types of Heirs Have Different Rules

Thanks to the original Secure Act, you might want to take extra care when deciding who you name as beneficiaries.

Starting in 2020, the Secure Act changed the rules for who could stretch out distributions from inherited retirement accounts and for how long. It created a new beneficiary category: "eligible designated beneficiaries." Only beneficiaries in this category are allowed to stretch distributions penalty-free over their own life expectancy. They include:

• Minor children of deceased account owner (Subject to the 10-year-rule when they reach the age of majority, which can be 18 or 21 depending on state. See below for more details.)
• Disabled individuals
• Chronically ill individuals
• Individuals not more than 10 years younger than deceased account owner
• Surviving spouses (Unlike other beneficiary types, surviving spouses can instead choose to take an inherited retirement account as their own. See Tip No. 4, below.)

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Let’s say a sibling who is five years younger than their deceased sibling inherits a traditional IRA. That younger sibling is an eligible designated beneficiary, and she can stretch distributions over her lifetime. If she lives another 30 years, she could potentially stretch that inherited account over those three decades.

To maintain the ability to stretch distributions, the nonspouse heir would need to take out at least the amount meeting her required minimum distribution (RMD) for each year. Note that the nonspouse heir RMD calculation is different from the RMD calculation for the original owner.

A nonspouse heir consults Table I (Single Life Expectancy) and uses the factor based on the age she turned on her birthday of the year she inherited the account. The prior year-end account balance is divided by that factor for the first RMD. In the next year, the heir subtracts 1 from that initial factor, and subtracts 1 in each subsequent year, to calculate her annual RMD.

Most nonspouse heirs, though, will fall into the designated beneficiary category. These heirs have up to 10 years to leave money in the retirement account. By the end of the 10th year following the original account owner’s death, all the money must be distributed.

Heirs of traditional accounts might want to take money out over the 10 years to help mitigate the tax bill. Wait until the 10th year to take the money out, and heirs of large accounts could end up with a huge tax burden.

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The distributed money “counts as ordinary income, and you need to plan for that,” said Maggi Keating, CFP®, a financial planner at FBB Capital Partners and the spouse of a retired Marine Corps colonel. Taxable distributions will be added to other taxable income heirs have. Heirs “could be strategic about it,” said Keating.

Within that 10-year window, if you will be retiring or experience a low income year, that could be the time to take a distribution from the inherited IRA.

If the inherited account is a Roth account, heirs qualify for tax-free withdrawals. In that case, an heir might want to let the money grow for 10 years and tap the account at the end since there will be no tax hit.

However, heirs who want to leave most of the money in the inherited retirement account need to keep on top of news from the IRS. A source of ongoing confusion for nonspouse beneficiaries subject to the 10-year window is whether they are required to take annual minimum distributions.

Originally, the prevailing thought was no. Then, “the IRS came out with guidance that if the IRA owner had started distributions, then the heir must take distributions ratably,” said Cmdr. Mark Luscombe, USNR (Ret), principal analyst for Wolters Kluwer Tax & Accounting. That means some heirs subject to the 10-year window would need to take RMDs, while others would not.

“The IRS flipflopping didn’t make this any less complicated,” said Eric Bronnenkant, CPA, CFP®, head of tax at financial firm Betterment.

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Because of all the confusion over whether RMDs are needed, the IRS has been annually waiving penalties for heirs subject to the 10-year window who have missed RMDs. The IRS announced in mid-April that this annual waiver for these heirs has been extended through 2024.

4. Surviving Spouses Have the Most Flexibility

While surviving spouses fall into the eligible designated beneficiary category, they actually have the most flexibility of any heir. Spousal heirs can choose to take inherited retirement accounts as their own. All the rules that apply to a retirement account owner would then apply.

For instance, a 65-year-old surviving spouse taking her deceased spouse’s retirement account as her own won’t have to tap that money until she reaches the age for her own RMDs, which is currently age 73.

Younger surviving spouses, though, might want to hold off on taking the money as their own. By remaining a beneficiary, a surviving spouse under age 59½ who needs access to the money can take advantage of the fact that beneficiaries aren’t subject to the early-withdrawal penalty of 10%.

After that half-birthday, she can choose to take the account as her own at any time. Again, only surviving spouses get this flexibility.

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5. Inheriting Roths Offer an Advantage

After the Secure Act shortened the holding period for inherited retirement accounts for many nonspouse beneficiaries, Roth accounts became even more appealing. An heir who inherits a Roth doesn’t inherit a tax bill. Those who inherit large accounts that can no longer be distributed over a lifetime particularly could benefit from inheriting tax-free Roth accounts.

But the person who makes the decision as to whether a Roth IRA is inherited versus a traditional IRA is the original owner. An heir cannot convert an inherited traditional IRA to a Roth IRA — only the original owner can do so.

When converting a traditional account to a Roth, you pay ordinary income tax on the amount being converted. The tradeoff is the account will then grow tax-free and distributions qualify for tax-free treatment, even when the account is passed on. “It’s a gift to heirs,” said Keating.

If you don’t want to pay the tax to convert a large traditional IRA, you could convert just part of it to a Roth. Or consider the tax situation of your named beneficiaries. You could pass on a taxable traditional IRA to a child in a low tax bracket and a tax-free Roth to a child in a high tax bracket.

There is a big difference if you are inheriting a 401(k) or TSP, notes Bronnenkant. Nonspouse heirs of these employer accounts can choose to convert traditional 401(k)s or TSPs to an inherited Roth IRA. “You can only convert the account if it is coming from an inherited employer account,” he said.