What Happens to Your IRA or 401(k) When You Die?

For most people, retirement accounts like IRAs and 401(k)s represent a lifetime of careful saving and investing. These accounts are often major assets within an estate, and they play a key role in how wealth is passed on to loved ones. 

However, few people realize how complex the rules are for what happens to these funds after death, or how many layers of taxation can apply. Without proper estate planning, a large portion of your retirement savings could be lost to federal and state taxes before your beneficiaries ever receive anything.

Understanding how Illinois and federal law treat retirement accounts after death can help you protect your family from unnecessary tax burdens and ensure that your savings go where you intend.

At Gierach Law Firm, our DuPage County estate planning attorney helps clients structure their retirement and estate plans with precision and foresight. We ensure your 401(k), IRA, and other assets are distributed according to your wishes while minimizing tax consequences.

What Happens to a Retirement Account After You Pass Away?

When you pass away, your IRA or 401(k) becomes part of your estate unless you have named specific beneficiaries. These accounts are considered tax-deferred, meaning taxes were postponed while you contributed and earned investment growth. The deferred taxes eventually come due. That happens when the funds are withdrawn, whether by you or your beneficiaries.

For beneficiaries, distributions from an inherited IRA or 401(k) are subject to federal income tax at their individual tax rate. Additionally, depending on the total value of your estate, your retirement accounts may be subject to federal and Illinois estate taxes before any distributions occur.

That means these accounts can be taxed multiple times: first through estate taxes, then through income tax on withdrawals. Without proper planning, this can dramatically reduce what your beneficiaries ultimately receive.

How Do Beneficiaries Pay Income Taxes on Retirement Accounts?

After estate taxes are calculated, your beneficiaries must still pay federal income tax on the funds they withdraw from your IRA or 401(k). The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, and its 2022 update (the SECURE 2.0 Act), introduced new rules for these distributions.

Under the current law:

• Most non-spouse beneficiaries must withdraw the entire balance of an inherited IRA or 401(k) within 10 years of the original owner’s death.
• Spouses, minor children, disabled or chronically ill beneficiaries, and those within 10 years of the decedent’s age are exceptions who may stretch withdrawals over their lifetimes.
• All withdrawals are taxed as ordinary income, based on the beneficiary’s tax bracket.

This means that a beneficiary in a high income bracket could see a large portion of the inherited account lost to federal income taxes, often 30 to 40 percent depending on the total amount withdrawn.

What Is a “Look-Through” Trust, and How Does It Affect Inherited Accounts?

Some people choose to name a trust as the beneficiary of their IRA or 401(k), rather than naming individual heirs directly. If done properly, this can help control how funds are distributed and provide asset protection.

However, not all trusts qualify as “look-through” or “see-through” trusts under IRS rules. A qualifying look-through trust allows required minimum distributions (RMDs) to be based on the life expectancy of the individual trust beneficiaries, rather than forcing the trust to liquidate the account within a short period.

To qualify, a trust must:

• Be valid under state and federal law
• Be irrevocable upon the owner’s death
• Identify all trust beneficiaries
• Provide a copy of the trust to the plan administrator by October 31 of the year after death

If a trust fails to meet these requirements, the account may need to be distributed and taxed much faster than intended. This can result in significant tax consequences and undermine your estate planning goals.

How Bad Can the Tax Burden for an Investment Account Really Get?

When multiple taxes overlap, the result can be staggering. Consider an example:

A person dies in Illinois with a $6 million estate, including $1 million in retirement accounts. Because the Illinois estate tax exemption is only $4 million, the estate could owe several hundred thousand dollars in Illinois estate tax, depending on the final calculation. If the total estate also exceeds the federal exemption, an additional federal estate tax could apply to amounts above that limit.

Then, when the beneficiaries withdraw the $1 million IRA balance, those distributions are taxed again as ordinary income, often at rates between 24 and 37 percent. Without proper planning, nearly half or more of the retirement account’s value could be lost to taxes.

How Can You Reduce or Avoid Double Taxation?

There are several strategies that can help minimize the tax burden on retirement accounts after death, but the right approach for you depends on your financial situation, the size of your estate, and who your beneficiaries are.

One of the most effective steps you can take is to designate appropriate beneficiaries. Spouses and certain types of trusts often have the ability to defer or spread out tax payments over a longer period of time, which can substantially reduce the immediate tax hit.

Another useful strategy involves using Roth conversions. By converting some or all of a traditional IRA into a Roth IRA during your lifetime, you pay income taxes on the converted amount now rather than leaving that obligation to your beneficiaries later. Because qualified withdrawals from Roth IRAs are tax-free, your heirs can receive those funds without facing additional federal income taxes after your death.

Charitable giving can also play a significant role in reducing taxes. If you plan to leave a portion of your estate to charity, donating retirement assets directly to a qualified organization can eliminate both estate and income taxes on those funds. 

Finally, coordinating your retirement accounts with your broader estate plan is essential. Your will, trust, and beneficiary designations should all work together without conflicting terms or unintended overlaps. A carefully aligned estate plan ensures that your assets pass to the right people in the most tax-efficient way possible.

Contact a Naperville, IL Estate Planning Lawyer

Planning for what happens to your IRA or 401(k) when you die is not just about numbers. It is about protecting your family’s future. By addressing the complex tax implications ahead of time, you can preserve more of your hard-earned savings for your loved ones.

For sophisticated guidance on retirement and estate planning, contact the respected DuPage County estate planning lawyer at Gierach Law Firm. Call 630-756-1160 to schedule a confidential consultation and learn how we can help you protect your assets, minimize taxes, and achieve peace of mind for the years ahead.