A Guide to Inheriting a 401(k)

Last Updated on 26th July 2022 by Jeffrey Camerda

To inherit a retirement account isn’t as simple as inheriting other assets, such as stocks and bonds. 401(k) beneficiaries must adhere to a set of guidelines set out by the Internal Revenue Service (IRS) to determine when and how much tax they must pay when inheriting a retirement plan from someone else. When it comes to 401(k)s, the following are the most crucial facts you need to know about them. You may want to consult with a financial professional when deciding how to manage your retirement funds.

Inherited 401(k) Plan: What Is It?

A 401(k) that has been handed down to a beneficiary after the death of the original owner is known as an inherited 401(k). If the original 401(k) holder is married, the surviving spouse is often the beneficiary. However, if the spouse so specifies in writing, they may choose another person as the beneficiary of their retirement plan in lieu of themselves.

To avoid a conflict of interest, a married person might relinquish his or her entitlement to inherit an employee benefit plan (401(k) in order to leave it to someone else. In addition to children, siblings, and other family members, a trust or charity might be included in this category as well.

The tax treatment of an inherited 401(k) depends on the following three factors:

  • The account holder’s relationship with you
  • The age you will be when you get the 401(k) inheritance 
  • Age at death of the account holder

Inheriting a 401(k) as a Spousal Beneficiary

Inheriting a 401(k) from your spouse may have a significant influence on how you handle the money and how much tax you have to pay. You have three options if you’re under the age of 59 1/2:

  • You may accept distributions from the plan, or you can leave the money in there.

Leaving inherited 401(k) assets in the plan does not trigger the 10% early withdrawal penalty if you decide to remove money from the account. Your ordinary income tax will still apply to any payouts you receive. Taking the minimum distributions from the account would be mandatory if your spouse died at the age of 70 1/2 or older. Again, there would be no penalty for early withdrawal, but you would have to pay income tax on the money you take out of the account. When a loved one passes away, you have the option of delaying taking RMDs until you reach the age of 70 1/2 if they were younger than that at the time of death.

  • Transfer the funds to an inherited IRA.

If you inherit money from a retirement plan, such as a 401(k), you’ll need an inherited Individual Retirement Account (IRA). Withdrawals are not subject to a penalty for being made too early. Even though you must provide minimal payments, the amount is calculated based on your own life expectancy rather than the amount needed of your spouse.

  • The third and last step is to deposit the funds into your personal individual retirement account (IRA).

There is no tax penalty for transferring an inherited 401(k) to an IRA if you already have one. For those under the age of 59 1/2, the rollover withdrawal will be handled as a regular dividend and subject to taxes. That means you’ll be taxed on the whole amount, as well as the 10% early withdrawal penalty.

If you’re above the age of 59 1/2, none of these alternatives will subject you to an early withdrawal penalty. In the event that your spouse was taking required minimum distributions from their 401(k) when they died, you would be able to continue receiving them or defer collecting them until you reach the age of 72.

Minimum distributions must be taken from your 401(k) if you are above the age of 72, no matter where the money is deposited or whether it is transferred to an inherited IRA.

Inheriting a 401(k) as a Non-Spouse

Non-spouses can now inherit 401(k)s under new laws that went into effect at the end of 2019. The Secure Act took effect at that time. Non-spouse beneficiaries of 401(k), IRA, and other defined contribution plans will have to accept their entire payments within 10 years following the death of the original account owner, under the new legislation, which goes into effect in 2020. Because of this, some non-spouse recipients may lose out on decades of tax-deferred growth.

Prior to becoming majority age, minors are exempt from the “mandated payment” provision, which means they have ten years to spend down any inherited funds they don’t want. In addition, those who qualify as handicapped or chronically sick might have their benefits extended for the rest of their lives. Under the former laws, beneficiaries under the age of 10 are also permitted to draw distributions from the original account holder’s estate.

As a non-spouse inheriting a 401(k), your options are limited by your beneficiary’s age at the time of the gift and the plan’s distribution restrictions. In certain cases, if the account holder has not yet reached the age of 70 1/2, the plan may enable you to stretch out dividends over a five-year period. Taking the five-year option means that if the account owner dies during that time period, you may be required to remove all of the account assets. In any situation, the withdrawals would be subject to income tax.

If the plan permits, you might potentially transfer the funds to an inherited IRA. Your life expectancy would be taken into consideration if you hadn’t already started taking needed minimum payouts. A minimal distribution is one that you must continue to get if they have already begun receiving them. Instead of using the account holder’s life expectancy, you might use your own.

What to Do If You Inherit a 401(k)

Depending on your tax planning goals, inheriting a 401(k) may provide some challenging tax issues. Talking to a tax expert and an estate planning specialist may help you choose the best course of action for reducing taxes while preparing for the future.

You’d need to name beneficiaries for your account to designate your 401(k) when you transfer it from one beneficiary to another, such as an inherited IRA or your own IRA. If you want to leave an inherited 401(k) to your children or other family members, you should consult with your estate planner to determine the tax consequences.

The bottom line

A 401(k) or any other form of retirement plan that you inherit must not be ignored. This is critical to bear in mind. Even though it’s tough to think about money after the death of a loved one, you’ll have to make a decision about what to do with it eventually. In an ideal world, you would have discussed the specifics with the account owner in advance so that you are ready to handle your newly acquired assets when the time comes.

Regardless of what you decide, you should always seek the advice of a financial specialist who can explain the tax and financial ramifications of various options.

Jeffrey Camerda

Dr. Jeffery Camerda, PhD, is a financial planner who specializes in wealth management and retirement planning. With a PhD in Economics and Financial Planning, Jeffery represents the highest level of financial planning expertise and achievement in the USA In addition to preparing you for a career in financial planning, a PhD in economics and finance also prepares you for academic pursuits, such as becoming a university professor in teaching or doing research. Here at the Wealth Builder, our financial advisory company was founded in 2007 and services all across the USA with over 16 years of expertise. In order to provide the finest advice and services, we pay close attention to the specific financial circumstances and requirements of each client. In order to guarantee that our clients don't get a sales pitch for insurance or investments, as well as a lack of conflict of interest from a prospective commission-bearing corporations, Jeffery focuses on fee-based services. Financial planning for wealth managers, financial well-being workshops, and personal financial planning packages are all part of the company's offering. Jeffrey Camarda, PhD, CFA, EA is also the founder of the Family Wealth Education Institute, is a member of the Financial Planning Association and serves as the Chairman of Camarda Wealth Advisory Group

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