How to Avoid Excise Tax or Penalty on a Distribution of Retirement Funds in an Estate

How to Avoid Excise Tax or Penalty on a Distribution of Retirement Funds in an Estate
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Retirees are sometimes confused about what to do with the unused funds in their retirement accounts. Sounds too good to be true, especially in today’s economy? Yes, it is possible because of the effects of compounding. A contribution as little as $500 a month can add up to more than one million after 35 or more years. Unused retirement assets are a great way to transfer wealth to the next generation but careful planning is required to avoid taxes in these inherited retirement accounts. There is an excise tax or penalty on distribution of retirement assets from an estate, if they are taken as a lump sum amount.

Why is Tax Planning of an Estate Important?

Tax planning is important because no one wants the fruits of a lifetime of hard work to go to Uncle Sam. That is what happens if the beneficiaries of inherited retirement accounts are not careful with tax planning. The assets in an estate can be subjected to so many taxes that after all the taxes are paid, there is not much left for the beneficiaries.

The first of the many taxes is the estate tax, sometimes called an inheritance tax. Thankfully, an estate tax is only applicable if the taxable estate is valued at more than $3.5 million. The taxable estate is the gross value of the estate minus allowable deductions. The gross total value of assets in an estate is calculated by adding the value of assets in retirement accounts, the value of the home, life insurance death benefits, fair value of assets in stocks, businesses and so on. Some of the allowable deductions are funeral expenses, debts owed at the time of death and marital deductions. The estate is subject to a 45 percent estate tax if the value of the taxable estate is more than $3.5 million.

Estate tax, however, is only a concern for those who are lucky enough to have $3.5 million in taxable assets. The rest of us are concerned about how to minimize taxes on the paltry sums that we inherit. Careful tax planning is important in this case too because if the assets in the retirement accounts are withdrawn as a lump sum amount, there is an early withdrawal penalty of 10 percent on the assets withdrawn.

How to Avoid Excise Tax or Penalty on Distribution of Retirement Assets from an Estate

In the case of Individual Retirement Accounts, if the original account owner named the estate as the beneficiary and he dies before the required beginning date for taking distributions, the balance should be distributed to the estate within a five year period. If he dies after the Required Minimum Distributions have begun, the beneficiaries can stretch the IRA distributions over the remaining life expectancy of the original owner as if he had lived. The longest possible time period that can be stretched in this case is 15.3 years, assuming that the account owner died at 71, just after taking his first RMD.

Naming the estate as the beneficiary is clearly bad estate planning. If the IRA owner had named a younger person as the beneficiary, he could have reaped the benefit of tax deferred growth of assets in the retirement account for a longer period. It is always better to name a beneficiary, especially one who has a longer life expectancy. For example, if the IRA owner has one son and two grandchildren, naming the grandchildren as beneficiaries will help in maximizing the tax deferral. There is also the option of naming the spouse as the beneficiary. A spouse can choose to treat the inherited IRA as the owner of the IRA and can even make contributions to the IRA. In any case, the most obvious choice for someone who is trying to avoid excise tax or penalty on distribution of retirement assets from an estate is not to take the assets as a lump sum amount.


  1. Publication 590 on IRAs by IRS,
  2. IRS Website,
  3. Retirement website,

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