11 Sep I’m inheriting two IRAs. What happens with the pension exclusion?

Q. I expect to inherit a traditional IRA and a Roth IRA from a relative (non-spouse) in the not-too-distant future. NJ Publication GIT-1 & 2, Retirement Income, states on page 37: “In general, pension, annuity, and IRA income received by a survivor or beneficiary is treated the same way as regular pension, annuity, or IRA income.” Does this mean that the pension exclusion will apply to distributions from the inherited traditional IRA? I also want to confirm that distributions from the inherited Roth IRA (open more than five years) will be non-taxable.
— Unsure

A. Thank you for your question.

We took it to Matthew DeFelice, a certified financial planner with U.S. Financial Services in Fairfield, and he started off with a look further down page 37.

It states:
1. When the distribution to the surviving beneficiary is subject to the New Jersey Inheritance Tax,* the contribution of the surviving beneficiary is the value of the annuity, pension, or retirement benefits as determined for Inheritance Tax purposes. The recipient can exclude from Income Tax the amount that represents the contribution, which is the value determined for Transfer Inheritance Tax purposes. Consult the Tax Guide on being an Executor for more details.

2. When the beneficiary receives benefits that are not subject to Inheritance Tax, they are entitled to exclude from income the remaining previously taxed contributions of the decedent. If the decedent’s contributions to the plan have already been recovered, all pension income the beneficiary receives is taxable and must be included in income.

*Contact the Division’s Inheritance Tax Section at (609) 292-5033 for more information.

DeFelice said from this, it appears that inherited traditional IRA income received by a beneficiary would be eligible for the New Jersey pension exclusion if he/she otherwise qualifies for the exclusion.

“Regarding the inherited Roth IRA, as long as it has been open for more than five years, the distributions will be 100% tax free,” he said. “Additionally, under the Secure Act 10-year rule, inherited Roth IRAs are not subject to RMDs in years one through nine, regardless of the deceased’s age.”

Receiving this money gives you more flexibility in your own planning, and with some creative outside-the-box thinking, it can really help you build wealth over the long term, DeFelice said.

“If you don’t need the money, you might want to leave the funds in the inherited Roth IRA for as long as possible for as much of the 10-year period as you can. Your account will grow tax-free and all of it can be withdrawn tax-free in the future,” he said.

Alternatively, given that there are no tax consequences on withdrawals, it may make sense to take distributions earlier, he said, offering this example:

Let’s say you are contributing after-tax dollars to your company’s traditional 401(k) plan, but they have a Roth 401(k) option. It may make sense to pull enough from your inherited Roth IRA to be able to afford maxing out your contributions to the Roth 401(k) instead, and maybe even contribute additional monies to your own Roth IRA if you are under the income limits, DeFelice said. This way instead of simply emptying out the inherited Roth over 10 years, you are essentially shifting those dollars back into your own Roth accounts allowing for a longer period of tax-free growth, he said.

“There are no blanket answers here – like `always do this’ or `never do that,’” DeFelice said. “As always, you should consult a qualified tax professional and/or financial planner to help you develop a strategy that makes the most sense for your particular situation.”

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This story was originally published in September 2024.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.