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In Illinois.

My 2 step-children (each around 10 yrs old) lost their dad recently. There was no will, no 401k, no life insurance, no savings and essentially no assets. Recently, we've been made aware he had a moderate pension payout amount and his two minor children were the sole beneficiaries. I'm really confused on what the options are with this money, their tax consequences, and which approach might be best for the children that will have zero need for this money till they finish college.
Some more background/context: Soon after his death, social security death benefits kicked in for the children (till they're 18) and that whole process went very smoothly. Since tax related questions follow, I'll mention the social security survivor benefits are about $20k/year per child. The majority of that is going right into a 529 plan so college will be taken care of, some is going to help cover the child support that stopped, and what's left over is just building up in their savings accounts.
The pension is a one time payout of about $40k per child.

Again, the children wouldn't need a penny of this till they finish college... and the plan would look something like them just using this money for a down payment on a house a couple years after college or whatever they choose. So this money will sit for ~15 years... and we (their mom... and I'm just helping give direction) feel it might as well try to grow in some index fund/ETF.

Our simple goal is to get this money in a brokerage account with the best overall tax efficiency possible assuming it won't be withdrawn for 15+ years. Their mom and I hate the idea of the government effectively saying "sorry little children that your dad killed himself.... now we want some of that money that is coming your way." If taxes are unavoidable on this money then, again, we're at least looking for what's the most tax efficient way to store/invest this money away for 15 years.

I see this as we have 3 options (of course their mom would have to be the guardian of whatever brokerage account we land on since they're so young):

1) "Cash it out" and put all of it into their own plain ol' individual brokerage account for them. I assume this means the $40k would be taxed now** (not sure actually)??? And any capital gains on the balance 15 years later would be taxed at the withdrawal.

** If it matters, I'm almost certain this pension accumulation was automatic (company paid) and wasn't contributed to by the father... so I assume that similar to company provided life insurance, it gets taxed?? But then I think the first $50k of employer provided life insurance doesn't get taxed.... so maybe this $40k of pension payout doesn't either?? Ugh.

2) Roll it into an inherited Roth IRA account. This is what we'd like to do if possible. I'm a big Roth IRA fan in general and I assume this is the most tax friendly approach???... so if that's an option I'm trying to understand tax consequences both now... and tax consequences 15 yrs later at withdrawal of the original amount plus any capital gains (I assume this $40k each needs to be taxed sometime, but maybe not???!!! **). I think any earnings would get the 10% penalty on withdraw in 15 years (minus a $10k first time homebuyer exception). But besides the 10% early withdrawal hit on the earnings... are there more taxes on the original $40k??

I found this paragraph in IRS Publication 575 (2020), Pension and Annuity Income:

Rollovers by nonspouse beneficiary. If you are a designated beneficiary (other than a surviving spouse) of a deceased employee, you may be able to roll over tax free all or a portion of a distribution you receive from an eligible retirement plan of the employee. The distribution must be a direct trustee-to-trustee transfer to your traditional or Roth IRA that was set up to receive the distribution. The transfer will be treated as an eligible rollover distribution and the receiving plan will be treated as an inherited IRA. For information on inherited IRAs, see What if You Inherit an IRA? in chapter 1 of Pub. 590-B.

That paragraph makes it maybe sound like I can effectively get this $40k into an inherited Roth IRA and this $40k would never be taxed??!! (Sounds too good to be true).

I'll also say that what to do with this money after college will be their decision, but if there is anyway 100% of this payout can stay in a Roth IRA until they retire (literally grow for 50+ years), I would strongly encourage them to do so. But, again, I'm not sure it's possible to get this payout into a Roth (and if so, does that money get taxed first??) and how long it can stay there.

3) Roll it into an inherited IRA (non-Roth). Again, unclear on what gets taxed when. My confused mind wants to simplify this option as "zero taxes now, full taxes plus 10% hit on the entire balance (minus maybe $10k for homebuyer exception) in 15 years when it's all withdrawn".... but I could be way wrong with that conclusion. If I somehow had to choose this option, I'd look into doing a Roth IRA conversion anyway, if possible. I'd only choose this, if option 2 wasn't an option.

I also think there is something about the SECURE act where inherited IRA distributions must be withdrawn within 10 years. But I also think there is an exception for a minor that was a child of the deceased... and I THINK they get 10 years AFTER they turn 18 (so it must be withdrawn by the time they are 28.... which is the plan anyway.)
What else am I missing/not realizing?
No matter what comes of this, this money shouldn't be considered as 'income', right?? Before this pension came to light, I had the understanding these Social Security survivor benefits weren't ever going to get taxed because one-half of these benefits plus "All of the child's other income, including tax-exempt interest." were under the $25k threshold. If this pension money somehow looks like income for 2021, I think they'll get taxed on their Social Security money too?
This took me way longer to write than one might think... as I tried to verbalize the situation and my confusion. I just want what's finally best for these children and don't even understand my options and their tax consequences enough to make an informed decision. Thank you very much for any insight!!



Submitted November 26, 2021 at 11:23AM by haggiebaby https://ift.tt/3FN4ceQ

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