Inheriting a 401k can be a significant financial event, bringing both potential benefits and considerations. Upon the death of an account holder, the designated beneficiary becomes responsible for managing the 401k. They have the option to keep the account as is or roll it over into an individual retirement account (IRA). If kept as a 401k, the beneficiary assumes ownership of the account and its assets. However, they may incur taxes and penalties if funds are withdrawn before reaching age 59½. Rolling over to an IRA offers greater flexibility and control over investments, but may have different tax implications depending on the type of IRA chosen. It’s important to consult with a financial professional to understand the implications of inheriting a 401k and make informed decisions about managing the account.
What Happens When You Inherit a 401k
When someone passes away, their assets are distributed according to their will or the laws of intestacy. If you inherit a 401k, there are a few things you need to be aware of.
Tax Implications of Inherited 401ks
Unlike most other types of retirement accounts, if a non-spouse individual inherits a 401k, you must withdraw the money from the account within a 10-year period. Inherited 401(k)s will be taxed as ordinary income. That means that you will have to pay income taxes on the amount of money that you withdraw each year. You will also be subject to a 10% penalty if you withdraw the money before you reach age 59.5, unless you meet one of the various exceptions.
Roth 401(k)s
- distributions from Roth 401(k)s are not subject to income tax, regardless of when the money is withdrawn.
- However, if you inherit a Roth 401(k) from someone who was age 59.5 or older, and, you do not take a Required Minimum Distribution (RMD) in the year the account owner died, the RMD for the deceased account owner for the year of death must be taken by December 31 of the following year.
If you inherit a 401k, it is important to talk to a financial advisor to learn more about the tax implications and to develop a withdrawal strategy that meets your needs.
Required Minimum Distributions
Once you inherit a 401k, you must begin taking Required Minimum Distributions (RMDs) each year, even if you are still working. RMDs are calculated based on your age and the balance of your account. The RMDs could be calculated differently depending on your age and the age of the original account owner when they died.
If you fail to take an RMD, you will be subject to a 50% penalty on the amount that you should have withdrawn. To avoid this penalty, it is important to calculate your RMD correctly and to make sure that you withdraw the money on time.
Beneficiary Options
When you inherit a 401k, you have several options for what to do with the money.
- Withdraw the entire balance. This is the simplest option, but it will also result in the highest tax bill.
- Roll the money over into an IRA. This will allow you to defer paying taxes on the money until you withdraw it.
- Leave the money in the 401k. This will allow the money to continue growing, but you will have to start taking RMDs once you reach age 72 (or 73 for those who reached 70½ after January 1, 2023).
Tax Implications of Inherited 401ks
Beneficiary Type Tax Implications Spouse Spouse can treat inherited 401(k) as their own. Non-spouse who is a designated beneficiary Non-spouse beneficiary must take RMDs based on their life expectancy Non-spouse who is not a designated beneficiary Account must be emptied within 10 years The best option for you will depend on your individual circumstances. It is important to talk to a financial advisor to learn more about your options and to make the best decision for your financial future.
Required Minimum Distributions for Inherited 401ks
When you inherit a 401(k), you must take required minimum distributions (RMDs) each year. The RMD is based on your age and the account balance as of December 31 of the previous year. You can take the RMD in a lump sum or in monthly installments.
Age RMD Percentage 72 3.65% 73 3.87% 74 4.08% 75 4.29% 76 4.50% 77 4.72% 78 4.93% 79 5.15% 80 5.38% 81 5.60% 82 5.83% 83 6.06% 84 6.29% 85 6.52% 86 6.75% 87 6.99% 88 7.22% 89 7.46% 90 7.70% 91 7.94% 92 8.19% 93 8.43% 94 8.68% 95 8.93% 96+ 9.18% If you do not take the RMD, you may be subject to a penalty of 50% of the amount that should have been withdrawn.
There are a few exceptions to the RMD rules. You do not have to take an RMD if you are:
- The surviving spouse of the account owner
- A minor child of the account owner
- A disabled beneficiary
- A beneficiary who is not more than 10 years younger than the account owner
If you inherit a 401(k), it is important to talk to a financial advisor to make sure you understand the RMD rules and how they apply to you.
Beneficiary Options for Inherited 401ks
When an account holder passes away, the 401k plan will distribute the funds according to the beneficiary designations on file. There are several options available for beneficiaries when they inherit a 401k:
- Spouse: The spouse is typically the primary beneficiary of a 401k. If the spouse inherits the account, they can roll it over into their own IRA or keep it in the 401k plan. They will have the option to take withdrawals from the account without paying any taxes or penalties.
- Non-spouse beneficiary: If the deceased did not name a spouse as the beneficiary, the funds will be distributed to a non-spouse beneficiary, such as a child, sibling, or friend. Non-spouse beneficiaries will have to pay taxes on any withdrawals from the account. They can choose to take withdrawals over their lifetime or take a lump sum distribution. If they take a lump sum distribution, they will have to pay taxes on the entire amount.
- Charity: The deceased can also choose to name a charity as the beneficiary of their 401k. If the charity inherits the account, the funds will be used to support the charity’s mission. The charity will not have to pay taxes on the funds.
The following table summarizes the tax implications of inheriting a 401k:
Beneficiary Type Tax Implications Spouse No taxes or penalties on withdrawals Non-spouse beneficiary Taxes on withdrawals Charity No taxes on withdrawals Estate Considerations
When you inherit a 401(k), it’s important to consider the estate tax implications. If the estate is subject to estate tax, the 401(k) will be included in the taxable estate. The estate tax rate for 2023 is 40% for estates worth over $12.92 million.
There are some steps that you can take to reduce the estate tax liability on your 401(k). One option is to make charitable contributions from the 401(k). Charitable contributions are not subject to estate tax. Another option is to name a non-profit organization as the beneficiary of your 401(k). Non-profit organizations are also not subject to estate tax.
Inherited 401ks
Once you inherit a 401(k), you have several options for what to do with it. You can:
- Take a lump sum distribution. This is the simplest option, but it will also trigger the highest amount of income tax.
- Roll the funds into an inherited IRA. This will allow you to defer paying income tax on the funds until you withdraw them.
- Leave the funds in the 401(k). This is a good option if you don’t need the money immediately and you want to continue to grow the funds.
The following table summarizes the tax implications of each option:
Option Income tax Estate tax Lump sum distribution Highest None Roll into an inherited IRA Deferred None Leave the funds in the 401(k) None Included in estate Well, there you have it, folks! Inheriting a 401(k) can be a bittersweet experience, but with the right knowledge and planning, you can make the most of it. Remember, it’s not just about the money; it’s about honoring the legacy of a loved one. Thanks for reading, and if you have any more questions or life decisions to make, be sure to swing by again. Until next time!