If you have been named as a beneficiary of a loved one’s 401(k), understanding how to manage the inheritance can be a way to honor their legacy. The best way to handle an inherited 401(k) depends on various factors, with your relationship to the primary account holder being the most important consideration.
Here are the essential rules to keep in mind when receiving an inherited 401(k) and how to avoid potential penalties.
Understanding an inherited 401(k)
A 401(k) is a retirement plan sponsored by an employer that allows employees to contribute towards their retirement savings. If there are remaining funds in the account upon the account holder’s passing, these funds can be passed on to beneficiaries. You can inherit a 401(k) directly from a spouse or from any account holder who has designated you as a primary or contingent beneficiary. In the case of being a contingent beneficiary, you would inherit the 401(k) if the primary beneficiary is deceased or cannot be located.
It is important to note that this article does not cover options for heirs who receive a retirement account through probate asset distribution, as different regulations apply in that scenario.
Key rules for inherited 401(k)s
The rules for handling an inherited 401(k) differ depending on whether the inheritance is from a spouse or a non-spouse. Your options for managing the inherited funds and the impact on your tax situation will vary based on your relationship to the deceased.
Furthermore, if you inherit a 401(k) as a minor child, a chronically ill or disabled individual, or someone who is not more than 10 years younger than the deceased, you will have different distribution rules. In such cases, you can take distributions based on your own life expectancy and may not be subject to the standard 10-year rule explained later in this article.
Rules and options for distribution when inheriting from a spouse
Surviving spouses have four primary options to consider:
- Take a lump sum distribution: This option allows you to receive the full value of the account immediately without incurring an early withdrawal penalty. However, the distribution will be taxed as ordinary income, potentially pushing you into a higher tax bracket. Opt for this choice only if you urgently need access to the entire account balance.
- Roll the inherited 401(k) into your own 401(k) or IRA: By transferring the inherited funds into your own retirement account, you give the money more time to grow. Early withdrawals before the retirement age of 59 ½ may be subject to a 10 percent penalty. Once you reach the age of 73, you must start taking required minimum distributions (RMDs) based on your life expectancy. While you can withdraw more than the minimum, failing to meet the minimum distribution requirement will result in penalties. Rolling over funds does not incur penalties, but converting a traditional 401(k) to a Roth account may lead to tax obligations.
- Directly transfer the funds into a new inherited IRA: By moving the inherited 401(k) into an inherited IRA, you can make withdrawals without facing early withdrawal penalties. This option can be beneficial for spouses who have not yet reached the age of 59 ½. Inside the inherited IRA, the distribution follows the rules specific to inherited IRAs.
- Keep the inherited 401(k) in its current plan: If you choose to leave the 401(k) in the inherited account, you will be required to take RMDs based on your life expectancy. This approach allows you to spread out withdrawals over time, minimizing tax implications. If you are over the age of 59 ½ and your spouse was taking RMDs before their passing, you can continue with that schedule or delay it until you reach the age of 73. For individuals already 73 years or older, taking RMDs is mandatory. If you are between 59 ½ and 73 and your spouse had not yet reached the age of 73, you can follow the RMD schedule based on when your spouse would have turned 73.
If you are over the age of 59 ½, none of the aforementioned options will subject you to penalty taxes for early withdrawals.
Rules and options for distribution when inheriting from a non-spouse
Non-spousal beneficiaries have three main choices, each with specific withdrawal regulations:
- Transfer funds directly into an inherited IRA: When moving funds into an inherited IRA, all funds must be withdrawn within a 10-year period. If the inherited money originated from a pre-tax 401(k), you will owe taxes on withdrawals from the traditional IRA. In the case of a Roth 401(k) or Roth IRA, there will be no tax implications as the contributions were made after taxes. Converting a pre-tax 401(k) to a Roth IRA typically incurs tax obligations.
- Opt for a lump sum distribution: This choice provides immediate access to the funds. However, taking a lump sum distribution may result in significant tax liabilities if it elevates your income or pushes you into a higher tax bracket. Withdrawals from a pre-tax 401(k) will be taxed at ordinary income rates, while withdrawals from a Roth 401(k) will not incur income taxes.
- Keep the funds in the 401(k) and withdraw over a 10-year period: While you can retain the funds in the 401(k) account, you will still need to withdraw the entire amount within 10 years to adhere to the 401(k)’s 10-year rule.
The 401(k) 10-year rule and its implications
Prior to the enactment of the 2019 SECURE Act, non-spouse beneficiaries had more flexibility in terms of withdrawal timing, particularly concerning required minimum distributions. Currently, most non-spouse beneficiaries are required to deplete the inherited account within a 10-year timeframe, known as the 10-year rule.
For non-spouse beneficiaries inheriting from accounts of individuals who passed away in 2020 or later, all funds must be withdrawn by the end of the 10th year following the account owner’s passing. Failure to comply may result in a 50 percent penalty on any remaining assets in the account. In cases where the account owner passed away in 2019 or earlier, beneficiaries also had the option to withdraw all funds by the end of the fifth year after the owner’s passing. If the account owner passed away in 2019 or earlier, RMDs could be based on the beneficiary’s life expectancy.
Non-spouse beneficiaries inheriting from accounts in 2020 or later, with exceptions for minor children, disabled or chronically ill individuals, or those within ten years of the deceased account owner’s age, can take RMDs based on their life expectancy. Once a minor child reaches the age of majority according to state laws, the 10-year rule will apply. The 10-year rule does not impact beneficiaries falling under the other two categories mentioned.
As of now, the IRS does not mandate minimum annual distributions for those subject to the 10-year rule for 401(k) accounts. Consequently, account owners could wait until the final year and withdraw the entire sum as a lump sum.
Conclusion
Managing an inherited 401(k) can be complex, and the decisions you make will hinge on various factors such as your relationship with the deceased, your age at inheritance, the age of the account owner at the time of passing, and whether the inherited account is pre-tax or post-tax. It is advisable to seek guidance from a reputable financial advisor before finalizing any decisions.
Editorial Disclaimer: It is recommended that all investors conduct thorough independent research on investment strategies before making any investment decisions. Additionally, past performance of investment products is not indicative of future price appreciation.
— Contribution by Rachel Christian, Bankrate