Inheriting a 401(k) isn’t always as simple as inheriting a home or other types of assets. The IRS has detailed rules about 401(k) beneficiaries that say when they must receive the 401(k) and how much tax they’ll pay. The rules for inherited 401(k)s are complicated and they are different for spouses than they are for other beneficiaries. If you’re currently the beneficiary of a 401(k) or you’ve recently inherited one, this guide will help you understand some important details you might need to know.
What is an inherited 401(k)?
An inherited 401(k) is a 401(k) that has been passed on to a beneficiary after the death of the account owner.
What is a 401(k) beneficiary?
A beneficiary is a person, or entity, who will receive the inherited 401(k). If you are married, the beneficiary is usually your spouse. If you want to name someone other than your spouse, your spouse must sign a waiver.
If you are unmarried, the beneficiary will be whoever you named such as your child, sibling, relative, or a charity. If you did not name anyone as a beneficiary, then your account will go to your estate.
What are your options when you inherit a 401(k)?
The distribution options are dependent on whether you are a surviving spouse or a surviving non-spouse. We will discuss both scenarios below.
401(k) beneficiary rules on surviving spouse
When a spouse inherits a 401(k), they get more options than other beneficiaries. If you inherit a 401(k) from your spouse, what you do with the inheritance, and the tax implications, may depend largely on your age. If you’re under age 59 1/2, there are four options for you to consider:
1. Transfer the money to your own retirement account.
Only surviving spouses can roll an inherited 401(k) into their own 401(k). Another option is to roll it into an IRA. This can be a Roth IRA or a traditional IRA that you already have, or you can open a new one. The money will be treated as your own and there will be no tax penalty for the rollover.
When you reach age 72, you must start making required withdrawals based on your own life expectancy. This may be the best option for you if you don’t need the money right away, because the money can keep growing in the account until you need it.
However, keep in mind that if you are under 59 ½ and withdraw money from that account, you may be subject to a 10% early withdrawal penalty.
2. Transfer the funds to an inherited IRA.
You can transfer the 401(k) funds into an inherited IRA. An inherited IRA is an individual retirement account that holds rollover funds from an inherited retirement plan. You can make withdrawals without triggering an early withdrawal penalty from an inherited IRA. This may be a good idea if you’re not 59 ½ yet and want access to the funds without a penalty.
It’s important to note that you must not take money directly out of the 401(k) account. The transfer must be made directly from the old account to the inherited IRA, otherwise, you may owe a tax penalty on that money.
3. Take a lump-sum distribution
A lump-sum distribution is when you withdraw all of the money from your inherited 401(k) at one time. This will give you a large amount of money straight away, which can be a good option if you need the money now. You will not pay an early withdrawal penalty.
However, you must pay taxes on those funds in that same year and the withdrawal may move you to a higher tax bracket depending on the amount of the distribution and your current income level.
4. Leave the money in the plan and take the required minimum distributions based on your life expectancy.
This method requires you to take required minimum distributions from the inherited 401(k) account based on your life expectancy. This can be calculated by dividing the total value of the inherited 401(k) by the distribution period next to your age in the IRS Single Life Expectancy Table.
Each subsequent year, you subtract one from the distribution period and divide the remaining balance by this new number. This enables you to spread your money out over time and minimize the effect the inherited 401(k) funds have on your taxes in a given year.
What happens if I’m a beneficiary spouse over 59 ½ and I inherit a 401(k)?
- If you’re over age 59 ½: You don’t need to pay the early withdrawal penalty for any of the above options. If your spouse was taking the required minimum distributions from their 401(k) when they passed away, then you have the option to continue taking them or to delay it until you turn 70 ½.
- If you’re already 70 ½ or older: You are required to take the minimum distributions regardless of what option you choose.
401(k) beneficiary rules on surviving non-spouse
As part of the SECURE Act, non-spouse beneficiaries of 401(k)s can take money from the account whenever they want, as long as everything is withdrawn from the inherited 401(k) account by the end of the 10th year following the account owner’s death. This is called the 10-year rule. The 10-year rule applies if the account owner died in 2020, or later. If you fail to empty the account within 10 years, then you will be subject to a 50% penalty on any assets remaining in the account.
You have four options as a surviving non-spouse beneficiary:
1. Transferring to an inherited IRA
For this option, you would set up an inherited IRA and transfer the money from the 401(k) to that account. There is no set amount to take each year. However, the account must be emptied at the end of the 10 years. Through an inherited IRA, you have more control on how the money is invested.
If the inherited 401(k) was pre-tax and you transfer it to a pre-tax inherited IRA, you will pay ordinary income tax on the amount you withdraw. Be careful when you withdraw. If you take out too much money from the inherited IRA, it might push you to a higher tax bracket.
If the inherited 401(k) was a Roth 401(k) and you transfer it to a Roth inherited IRA, you won’t pay taxes when you withdraw since Roth accounts grow tax-free. In this case, it may be best to wait until year 10 before withdrawing.
It’s also possible to transfer a pre-tax inheritance 401(k) to an inherited Roth IRA and pay the income tax on the conversion in that tax year. You may want to do this if you’re in a particularly low-tax bracket during that year. The money will then begin to grow tax free. The converted inherited Roth IRA still has required minimum distributions obligations.
2. Take a lump-sum distribution
This will mean that you will have access to the money quickly, but you will pay more in taxes. This may also push you into a higher income tax bracket. If the inherited 401(k) is pre-tax dollars, then you may need to pay federal and possibly state and local taxes when you withdraw that money.
3. Withdraw funds over a 5 or 10 year period
You can choose to withdraw the funds from the inherited 401(k) whenever you want, as long as all of the money is withdrawn by the end of the 5th or 10th year, following the account owner’s death. If the account owner died in 2019 or earlier, then the 5-year rule applies. If they died in 2020 or later, the 10-year rule applies.
4. Take the required minimum distributions based on your life expectancy.
This strategy only applies if the account owner died prior to 2020. If the account owner died in 2020 or later, only the following individuals can use this strategy:
– Minor children of the account owner (until they reach the age of majority then the 10-year rule begins)
– Disabled or chronically ill individuals
– Anyone who is not more than 10 years younger than the account owner at the time of their death
Which option should I choose if I am a surviving non-spouse beneficiary?
If your inherited 401(k) is on the smaller side, then you may want to transfer it to an inherited IRA, let it grow, and then take the distributions at the end of the 10 year period. If your inherited 401(k) is a large amount then you may want to take distributions over a 10 year period to avoid any extreme tax changes.
Also, if you are planning to retire or move to a state with no/lower income taxes then you may want to consider waiting to take money from your inherited 401(k). It would be worthwhile to speak to a financial advisor or a tax specialist to determine which option is best for you based on your situation.
Does the 10-year rule apply to minors?
The 10-year rule doesn’t apply to minors until they reach the age of majority (usually around 18-21 depending on state rules). Once they reach the age of majority, they have to empty the account within 10 years.
Inherited 401(k) Taxes
You will need to pay ordinary income taxes (federal, state, local) when withdrawing money from a pre-tax inherited 401(k). You’ll want to manage your tax bracket well, and withdraw enough to fill up the lower tax brackets, but not so much that you pay tax in the higher brackets.
Do beneficiaries pay tax on 401(k) inheritance?
There are tax consequences that come with inheriting a 401(k). You have to pay income taxes on any pre-tax money you withdraw. This may also move you into a higher income tax bracket depending on the amount received. This could complicate your tax situation so it’s important to work with a financial advisor or tax specialist.
The inherited 401(k) is taxed based on four key factors:
- Your relationship to the account holder
- Your age when you inherit the 401(k)
- The account owner’s age when they die
- Whether the inherited 401(k) is pre-tax or a Roth 401(k).
How do I avoid inheritance tax on my 401(k)?
If the inheritance 401(k) is pre-tax, then you will have to pay taxes at some point when you withdraw the money. You can lower your taxes by timing the withdrawals during years when you are in a lower tax bracket.
Other Inheritance 401(k) Questions You May Have:
What is the 5-year rule on inherited 401(k)s?
The 5 year rule states that you can take the money out whenever you want, as long as everything is withdrawn from the inherited 401(k) account by the end of the 5th year following the account owner’s death. The 5 year rule applies if the account owner died in 2019, or earlier. After 2019, this rule was replaced with the 10 year rule.
Can you disclaim inheritance money?
Yes, you can disclaim inheritance money. If you prefer the money to go to the alternative beneficiary, then you don’t have to accept it. This must happen before you take possession of the funds and within 9 months after the death of the account owner. However, keep in mind, once you disclaim the money, you can no longer get the money back if you change your mind.
Losing a loved one is devastating and the last thing you want to do is deal with financial tasks. However, figuring out what to do with an inherited 401(k) can be a complex process and it’s important to think through all of the options available. If you have inherited a 401(k), you may want to speak to a financial advisor who can help you decide what approach is best for you. Your decision will affect the amount of taxes that you pay and ultimately, how much money you will end up with.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.