When you inherit a 401(k) retirement account, there are tax rules and other guidelines that beneficiaries must follow in order to make the most of their inheritance.
Inheriting a 401(k) isn’t like getting a simple inheritance, e.g. cash, property, or jewelry. How you as the beneficiary must handle the account is determined by your relationship to the deceased, your age, and other factors.
Understanding the tax treatment of an inherited 401(k) is especially important, as 401(k) accounts are tax-deferred vehicles, so regardless of your status as a beneficiary you will owe taxes on the withdrawals from the account, now or later.
What Is an Inherited 401(k)?
As the name suggests, an inherited 401(k) is an employer-sponsored retirement plan that is bequeathed to an individual, either a spouse or a non-spouse.
When an individual sets up their 401(k) to begin with, they generally fill out a beneficiary form. This form may include their spouse (if the account holder was married), children, siblings, or others.
In most cases, when the account holder of a 401(k) dies, the account is automatically bequeathed to the surviving spouse, unless the will specifies otherwise. This is not the case if your partner dies and you weren’t married. In that case, the 401(k) does not pass to the surviving partner, unless they are officially designated as an account beneficiary.
What to Do If You’re Inheriting a 401(k)
The rules for inheriting a 401(k) are different when you inherit the account from a spouse versus someone who wasn’t your spouse. Depending on your relationship, you’ll have different options for what you can do with the money and how those options affect your tax situation.
Remember, a 401(k) is a tax-deferred retirement account, and the beneficiary will owe taxes on any withdrawals from that account, based on their marginal tax rate.
💡 Quick Tip: Did you know that a traditional Individual Retirement Account, or IRA, is a tax-deferred account? That means you don’t pay taxes on the money you put in it (up to an annual limit) or the gains you earn, until you retire and start making withdrawals.
Inheriting a 401(k) From a Spouse
A spouse has a number of options when inheriting an IRA. But be careful; there are a number of wrinkles given that the rules have changed in the last few years.
• You could rollover the inherited 401(k) into your own 401(k) or into an inherited IRA: For most spouses, taking control of an inherited 401(k) by rolling over the funds is often the smartest choice. A rollover gives the money more time to grow, which could be useful as part of your own retirement strategy. Also, rollovers do not incur penalties or taxes. (But if you convert funds from a traditional 401(k) to a Roth 401(k) or a Roth IRA, you will likely owe taxes on the conversion to a Roth account.)
Also remember that once the rollover is complete, traditional 401(k) or IRA rules apply, meaning you’ll face a 10% penalty for early withdrawals before age 59 ½.
And when you reach age 73, you must start taking required minimum distributions (RMDs). Because RMD rules have recently changed, owing to the SECURE Act 2.0, it may be wise to consult a financial professional to determine the strategy that’s best for you.
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• Take a lump sum distribution: Withdrawing all the money at once will not incur a 10% early withdrawal penalty as long as you’re over 59 ½, but you’ll owe income tax on the money in the year you withdraw it — and the amount you withdraw could put you into a higher tax bracket.
• You can reject or disclaim the inherited account, passing it to the next beneficiary.
• Last, you could leave the inherited 401(k) where it is: If you don’t touch or transfer the inherited 401(k), you are required to take RMDs if you’re at least 73. If you’re not yet 73, other rules apply and you may want to consult a professional.
Inheriting a 401(k) from a Non-Spouse
The options for a non-spouse beneficiary (e.g. a child, sibling, etc.) are far more limited. For example, as a non-spouse beneficiary you cannot rollover an inherited 401(k) into your own retirement account.
• You can “disclaim” or basically reject the inherited account.
• If the account holder died in 2019 or earlier, you can take withdrawals for up to 5 years — as long as the account is empty after the 5-year period. If the account holder died in 2020 or after, you have 10 years to withdraw all the funds. You must start taking withdrawals starting no later than Dec. 31 of the year after the death of the account holder. These rules are known as the 5-year and 10-year rules.
• A positive point to remember: If you are a non-spouse beneficiary and younger than 59 ½ at the time the withdrawals begin, you won’t face a 10% penalty for early withdrawals.
The exception to this rule is if you’re a minor child, chronically ill or disabled, or not more than 10 years younger than the deceased, you can take distributions throughout your life.
💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
How RMDs Impact Inherited 401(k)s
If the account holder died prior to Jan. 1, 2020, anyone can use the so-called “life expectancy method” to withdraw funds from an inherited IRA. That means taking required minimum distributions, or RMDs, based on your own life expectancy per the IRS Single Life Table (Publication 590-B).
But if the account holder died after Dec. 31, 2019, the SECURE Act (also known as the “Setting Every Community Up for Retirement Enhancement Act of 2019”) outlines different withdrawal rules for those who are defined as eligible designated beneficiaries.
What Is an Eligible Designated Beneficiary?
To be an eligible-designated beneficiary, and be allowed to take RMDs based on your own life expectancy, an individual must be one of the following:
• A surviving spouse
• No more than 10 years younger than the original account holder at the time of their death
• Chronically ill
• A minor child
Individuals who are not eligible-designated beneficiaries must distribute (i.e. withdraw) all the funds in the account by December 31st of the 10th year of the account owner’s death.
Eligible-designated beneficiaries are exempt from the 10-year rule: With the exception of minor children, they can take distributions over their life expectancy.
Minor children must take any remaining distributions within 10 years after their 18th birthday.
How to Handle Unclaimed Financial Assets
What if someone dies, leaving a 401(k) or other assets, but without a will or other legally binding document outlining the distribution of those assets?
That money, or the assets in question, may become “unclaimed” after a designated period of time. Unclaimed assets may include money, but can also refer to bank or retirement accounts, property (e.g. real estate or vehicles), physical assets such as jewelry.
Unclaimed assets are often turned over to the state where that person lived. However, it is possible for relatives to claim the assets through the appropriate channels. In most cases, it’s incumbent on the claimant to provide supporting evidence for their claim, since the deceased did not leave a will or other documentation officially bequeathing the money to that person.
Inheriting a 401(k) can be a wonderful and sometimes unexpected financial gift. It’s also a complicated one. For anyone who inherits a 401(k) — spouse or otherwise — it can be helpful to review the options for what to do with the account, in addition to the rules that come with each choice.
In some cases, the beneficiary may have to take required distributions (withdrawals) based on their age. In some cases, those required withdrawals may be waived. In almost all cases, withdrawals from the inherited 401(k) will be taxed at the heir’s marginal tax rate.
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