Inheriting a 401(k) on the death of the account owner isn’t always as straightforward as inheriting other types of assets. The IRS has certain rules that 401(k) beneficiaries must follow to determine when and how much tax they’ll pay to inherit someone else’s retirement plan. If you’re currently the beneficiary of a 401(k) or you’ve recently inherited one, here are the most important things you need to know. Consider working with a financial advisor as you make decisions about handling retirement money, especially one who can answer your difficult inheritance questions.
What Is an Inherited 401(k)?
An inherited 401(k) is simply a 401(k) that’s been passed on to a beneficiary at the death of the original owner. If the original 401(k) owner is married, the inheritor is usually the surviving spouse. The exception to the rule is if the spouse signs a waiver allowing them to name someone else as their plan beneficiary.
If a spouse waives his or her right to inherit a 401(k) or the account owner is unmarried, the account can be left to whomever the account owner chooses. That includes children, siblings or other relatives, as well as a trust or charity.
How an inherited 401(k) is taxed is based on three key factors:
- Your relationship to the account owner
- Your age when you inherit the 401(k)
- The account owner’s age at death
Inheriting a 401(k) as a Spousal Beneficiary
If you inherit a 401(k) from your spouse, what you decide to do with it and the subsequent tax impacts may depend largely on your age. If you’re under age 59 1/2, you can do one of three things:
1. Leave the Money in the Plan and Take Distributions
If you decide to leave inherited 401(k) funds in the plan, you can take withdrawals from the account without triggering the 10% early withdrawal penalty. You’d still pay regular income tax on any distributions you take. If your spouse was age 70 1/2 or older at death, you would have to take required minimum distributions from the account. Again, there would be no early withdrawal penalty but you would pay income tax on the withdrawals. If they were younger than 70 1/2 when they passed away, you could wait to take RMDs until you turn 70 1/2.
2. Transfer the Funds to an Inherited IRA
An inherited IRA is an individual retirement account that’s designed to hold rollover funds from an inherited retirement plan, including 401(k)s. You can make withdrawals without triggering an early withdrawal penalty. This kind of account would require you to take minimum distributions but the amount would be based on your own life expectancy, not the amount your spouse would have been required to take.
3. Transfer the Money to Your Own IRA
If you already have an IRA in place you could roll an inherited 401(k) into it with no tax penalty. The catch is that if you’re under age 59 1/2 when you execute the rollover, the withdrawal will be treated like a regular distribution. That means you’ll pay income tax on the full amount, along with the 10% early withdrawal penalty.
If you’re over age 59 1/2, you won’t have to worry about paying the early withdrawal penalty with any of these options. If your spouse was taking required minimum distributions from their 401(k) when they passed away, you’d have the option to continue taking them or delay taking them until you turn 72.
If you’re already 72 or older, you’d be required to take minimum distributions – regardless of whether you leave the money in the 401(k), transfer it to an inherited IRA or roll it over to your existing IRA.
Inheriting a 401(k) as a Non-Spouse
The rules governing how non-spouses inherit 401(k) changed at the end of 2019. That’s when the Secure Act came into effect. The new law mandated that beginning in 2020, non-spouse beneficiaries of 401(k)s, IRAs and other defined contribution plans had to take full payouts within 10 years after the death of the initial account owner, sometimes referred to as the 10-year rule. That means some non-spouse beneficiaries would miss out on tax-deferred growth that could have stretched decades.
Here are the three main considerations of inheriting a 401(k) as a non-spouse:
- Mandatory Payout Rule Exceptions: The mandatory payout rule doesn’t apply to minors until they’ve reached the age of majority, at which point, they have 10 years to empty the account they inherited. Additionally, people who meet the government definition of disabled or chronically ill can stretch out withdrawals for their lifetime. Beneficiaries who are not more than 10 years younger than the original account holder at the time of death are also allowed to take distributions under the old rules.
- Age of Account Owner: What you do with an inherited 401(k) as a non-spouse is tied to how old the account owner was when you inherited the plan and the plan’s distribution rules. If the account owner hadn’t yet turned 70 1/2, it’s possible that the plan may allow you to spread distributions out over your lifetime or spread them out over a five-year period. If you take the five-year option, you may have to fully withdraw all of the account assets by the end of the fifth year following the account owner’s passing. In either case, you’d owe income tax on the withdrawals.
- Account Rollover: You could also roll the account over to an inherited IRA if the plan allows it. In that scenario, the required minimum distributions would be based on your life expectancy, assuming the account owner hadn’t begun taking them yet. If they had already started taking minimum distributions, you’re required to continue taking those distributions. You could, however, base the distribution amount on your life expectancy instead of the account owners.
What to Do If You Inherit a 401(k)
Inheriting a 401(k) could raise some tricky tax questions if you’re concerned with minimizing your tax liability. Talking to a tax professional and an estate planning specialist can help you decide which course makes the most sense to reduce taxes while planning ahead for the long term.
For instance, if you’re rolling an inherited 401(k) to an inherited IRA or to your own IRA, you’d need to name beneficiaries for your account. You may want to ask your estate planner what the tax implications are for passing an inherited 401(k) on to your children or other family members.
The Bottom Line
The most important thing to keep in mind when inheriting a 401(k) or any other type of retirement plan is that you can’t simply ignore it. While it may be difficult to think about money when a loved one has passed away, you’ll eventually need to decide what to do with it. Ideally, you’ve talked the details over with the account owner well beforehand so that when the time comes, you’re prepared to manage your newly inherited assets.
Tips for Managing an Inherited 401(k)
- If you’ve inherited a 401(k) or IRA of significant value, you should meet with a financial advisor as soon as possible. An advisor can help you determine the best way to minimize taxes on your inheritance, as well as the best way to invest the money. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Consider how your inherited 401(k) impacts your overall retirement situation. SmartAsset’s retirement calculator looks at your current and projected savings to determine whether you’re on pace for a secure retirement.
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