401(k) Inheritance Tax Rules for Estate Planning

Inheriting a 401(k) comes with some complex tax rules. When the estate plan includes workplace plans and individual retirement accounts (IRAs), they’re treated differently than  real estate or other assets. If you anticipate inheriting a 401(k) from a parent, a spouse, or someone else, it’s important to understand the tax liability associated with making withdrawals from these accounts.

A financial advisor can help you find the right path forward so you make a more informed decision about your estate plan.

How Is a 401(k) Taxed When Inherited?

Traditional 401(k) plans are funded with pre-tax dollars. This creates a tax advantage during working years, but withdrawals are taxed at their ordinary income tax rate in retirement. The exception is Roth 401(k) plans. With a Roth 401(k), contributions are made using after-tax dollars. So qualified withdrawals from these plans are 100% tax-free.

However, a 401(k) isn’t immediately subject to income taxes when a person dies and passes the account to an heir. Instead, income taxes are triggered when the beneficiary begins withdrawing the inherited assets.

How an inherited 401(k) is taxed depends on three things:

• The relationship between the account owner and the person inheriting the 401(k)
• The age of the person inheriting the 401(k)
• How old the account owner was when they died

How you choose to receive an inherited 401(k) can also influence when you pay taxes on it.

Who Pays Tax on Inherited 401(k) Assets?

The person who inherits a 401(k) is ultimately responsible for paying any taxes owed on money that’s withdrawn from the account. When someone enrolls in a 401(k) plan at work or establishes a solo 401(k) for themselves, they can choose one or more beneficiaries. The account beneficiaries are entitled to receive any assets in the account once the original account owner passes away.

Spouses are often named as primary beneficiaries, meaning they’re entitled to receive the remaining funds in the account. If a primary beneficiary has predeceased the account owner or for some reason they don’t want to claim an inherited 401(k), the money would then go to the next contingent beneficiary named.

The beneficiary who inherits 401(k) assets is responsible for paying income tax on the money when they begin withdrawing it. However, the assets in the account would be taxed at the beneficiary’s ordinary income tax rate, not the tax rate of the original account owner. Inheriting a 401(k) can push a beneficiary into a higher tax bracket, depending on how much they receive from an inherited 401(k).

What Do I Do With an Inherited 401(k)?

What you should do with an inherited 401(k) depends largely on your relationship to the original account owner and the options offered by the plan. Spouses generally have the most flexibility. They can roll the inherited funds into their own 401(k) or IRA, treat it as an inherited account or delay taking required distributions until they reach retirement age. These choices allow spouses to align the inherited account with their existing retirement strategy while maintaining favorable tax treatment.

Options for Spousal Beneficiaries

If you were married to the original account owner, you have the following options when inheriting a 401(k) account:

• Withdraw it: If you need the money from an inherited 401(k) for medical bills, college costs or other reasons, you can withdraw all of it in a lump sum. Of course, you would have to pay taxes on the distribution, and potentially a 10% early withdrawal penalty.
• Roll it over: You could also choose to rollover inherited 401(k) funds into your own 401(k) plan or to an IRA. This allows the money to continue growing and the funds would be treated as your own for tax purposes. You can also make new contributions to the account.
• Leave it in the account: If the plan permits it, you could choose to leave the money in your spouse’s 401(k) plan and pay income taxes on distributions as you go.
• Transfer it to an inherited IRA: You could also roll an inherited 401(k) into a new inherited IRA. You could arrange for the 401(k) plan custodian to transfer assets directly on your behalf to avoid the money being taxed as a distribution. An inherited IRA would allow you to make early withdrawals without triggering a 10% tax penalty.

Whether your spouse had started taking required minimum distributions (RMDs) at the time of their death will determine how and when you’ll need to start withdrawing the inherited assets.

Options for Non-Spouse Beneficiaries

If you’re a non-spouse beneficiary and inherit a 401(k), you have less flexibility and fewer options. Non-spouse beneficiaries cannot roll the 401(k) into their own retirement account. Instead, they can take a lump sum or transfer the funds to an inherited IRA subject to specific distribution rules.

For deaths that occurred after 2019, non-spouse beneficiaries typically must follow the 10-year rule for distributions. This means they must empty the inherited IRA within 10 years of the original account owner’s death. Before 2020, non-spouse beneficiaries were permitted to stretch their distributions out based on their own life expectancy, potentially reducing the size of their annual withdrawals and the resulting tax liability. However, the SECURE Act of 2019 ended the “stretch IRA” and instituted the 10-year rule.

So you could choose a lump sum distribution or spread distributions out over 10 years. Either way, you’ll owe income tax on the amounts you take from the plan.

Required Minimum Distributions for Inherited 401(k)s

An inherited 401(k) is subject to required minimum distribution rules that dictate when and how beneficiaries must begin taking money out of the account. These rules vary depending on whether the beneficiary is a surviving spouse or another individual, and on the status of the original account owner at the time of death. Because each withdrawal is taxed as ordinary income, the timing of distributions can significantly influence the total tax cost.

If you inherit a 401(k) as a spouse, you have more choices. You may roll the funds into your own retirement account and follow the normal schedule for RMDs that applies once you reach the required age. If the original account holder had not yet started withdrawals, you can also delay distributions, allowing the balance to continue growing on a tax-deferred basis until you are required to begin RMDs yourself.

Non-spouse beneficiaries face stricter limits under the SECURE Act. In most cases, the account must be emptied within 10 years of the original owner’s death. While you are not required to withdraw a set amount each year during that period, the full balance must be distributed by the end of the 10th year. Since each withdrawal is taxed as income, this rule often accelerates taxes and may push beneficiaries into higher tax brackets.

Another factor is whether the deceased had already begun RMDs. If they had, you may need to continue taking annual withdrawals beginning the year after death, even while still complying with the 10-year deadline. Missing a withdrawal can result in a steep RMD penalty equal to a percentage of the required amount. Careful planning of when and how much to withdraw can help spread the tax burden more evenly and avoid unnecessary penalties.

Want to understand the tax impact of tapping your retirement savings? Try our calculator for a quick estimate.

How Do I Avoid Inheritance Tax on My 401(k)?

While 401(k) funds are not typically subject to federal inheritance or estate taxes for most individuals, they are subject to income tax when distributed to beneficiaries. To minimize the tax burden, consider strategic planning options.

One approach is converting a traditional 401(k) to a Roth 401(k) during your lifetime. Roth accounts are funded with after-tax dollars, and qualified distributions to beneficiaries are tax-free. However, converting to a Roth triggers income taxes at the time of conversion, so careful planning is needed.

Another option is naming a charity as the beneficiary of your 401(k). Charities are exempt from income tax, allowing the funds to pass tax-free. This strategy works well for individuals with charitable intentions and other assets to leave to heirs.

There’s one other option for avoiding income taxes on an inherited 401(k). You could disclaim the inheritance altogether. If you were to disclaim an inherited 401(k), the money would pass on to the next contingent beneficiary. This is something you may consider if you’d rather avoid 401(k) inheritance tax headaches, you don’t necessarily need the money or you would simply rather see it go to someone else.

Bottom Line

Inheriting a 401(k) from a spouse or parent could catch you off-guard financially if you’re unaware of the potential tax implications of withdrawing the money. If you know that you’re listed as a beneficiary of someone’s 401(k) or a similar plan such as a 403(b) or 457 account, planning ahead can help you to avoid potentially tricky tax situations.

Tax Planning Tips

• Consider talking to a financial advisor about how inheriting a 401(k) may affect your finances and your options are for minimizing the resulting tax bill. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you have a 401(k) that you plan to pass on to someone else, it’s important to consider how that may affect your estate plan as a whole. And during your lifetime, you may want to leverage your 401(k) to its maximum potential to realize the largest tax benefit. That can mean maxing out contributions annually, including catch-up contributions once you reach age 50. Fully utilizing a 401(k) or IRA can help to offset some of what you might pay in capital gains tax if you’re also investing in a taxable brokerage account.

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