When you inherit a 401(k) from a parent, you have several options on how to handle it. One option is to cash out the account and pay taxes on the proceeds. Another option is to roll the account over into an IRA or another 401(k) plan, which allows you to avoid paying taxes on the money until you withdraw it in retirement. If you inherit a 401(k) from a parent who died before reaching age 72, you have 10 years to withdraw the money. If you inherit a 401(k) from a parent who died after reaching age 72, you have to start taking withdrawals immediately.
Inheriting a 401(k) From a Parent
When a parent passes away, their 401(k) may be distributed to their beneficiaries. If you inherit a 401(k) from your parent, it is important to understand the tax implications and the options available for withdrawing the funds.
Withdrawing Funds: Tax Implications
When you inherit a 401(k), you can inherit it either as a non-spousal beneficiary or as a spousal beneficiary. The tax implications associated with the distribution of the funds will be different based upon the beneficiary designation. Following is how the funds are taxed in each scenario:
Non-Spousal Beneficiary
- Withdrawal of funds from a 401(k) by a non-spousal beneficiary will be taxed as ordinary income.
- The beneficiary will also be subject to a 10% early withdrawal penalty if they are under the age of 59 ½.
- The beneficiary can defer taxes by rolling the funds over to an IRA or another 401(k).
Spousal Beneficiary
- A spousal beneficiary can defer taxes by rolling the funds over into a new IRA in their own name.
- The funds can be withdrawn by the spouse at any age without penalty.
- If the spouse begins taking withdrawals and they are not yet 59 ½, the penalty is 4% per year per distribution until the spouse reaches age 59 ½.
Required Minimum Distributions
If the beneficiary is not a spouse, they are required to start taking annual distributions from the 401(k) as early as December 31 of the year following the year of death. The amount of the required minimum distribution is calculated based on the beneficiary’s age and the account balance.
Withdrawal Options for Non-Spousal Beneficiaries
If you are a non-spousal beneficiary, you have several options for withdrawing funds from your inherited 401(k):
- Withdraw the funds all at once. This will result in paying taxes and penalties on the entire amount if you are under 59 ½.
- Withdraw the funds gradually. This will allow you to spread out the tax implications and avoid the early withdrawal penalty.
- Roll the funds over to an IRA or another 401(k). This will defer taxes until you start taking withdrawals from the new account.
Withdrawal Option Tax Implications Early Withdrawal Penalty Withdraw all funds at once Pay taxes and penalties on entire amount if under 59 ½ 10% if under 59 ½ Withdraw funds gradually Spread out tax implications and avoid early withdrawal penalty None if withdrawals start after age 59 ½ Roll funds over to IRA or 401(k) Defer taxes until withdrawals start from new account None Steps to Take When You Inherit a 401k From a Parent
Losing a parent is always difficult, and dealing with their financial affairs can be overwhelming. If you’ve inherited a 401(k) from your parent, here’s what you need to know.
Required Minimum Distributions (RMDs)
Once you inherit a 401(k), you must take Required Minimum Distributions (RMDs) starting the year after you inherit the account. RMDs are calculated based on your age and the account balance. You can find calculators online to help you determine your RMD.
Failure to take RMDs can result in a 50% penalty on the amount you should have withdrawn. You can avoid the penalty by rolling the inherited 401(k) into an Inherited IRA within 60 days of receiving it. With an Inherited IRA, you can continue to take RMDs based on your own age rather than the age of the original account holder.
Other Considerations
- Beneficiary Designation: Check the 401(k) documents to see who the beneficiary is. If you’re not the beneficiary, you may not be entitled to the account.
- Taxation: Inherited 401(k)s are taxed as income when you take withdrawals. If you roll the account into an Inherited IRA, you can delay taxation until you take withdrawals.
- Estate Taxes: If the inherited 401(k) is part of your parent’s estate, it may be subject to estate taxes. Consult with an estate planning attorney for guidance.
Distribution Options
Distribution Option Pros Cons Lump Sum - Get the money immediately
- Avoid ongoing management fees
- May be subject to higher taxes
- May deplete the account quickly
Installments - Spread out the tax liability
- Preserve the account’s value
- May not have immediate access to all the funds
- Ongoing management fees
Inherited IRA - Tax-deferred growth potential
- Can take RMDs based on your own age
- May not be eligible for all 401(k) investments
- Required to take RMDs each year
When inheriting a 401(k) from a parent, it’s important to understand your options and make informed decisions. Consulting with a financial advisor or estate planning attorney can help ensure you make the best choice for your financial future.
Rollovers and Beneficiary Options
When you inherit a 401(k) from a parent, you have several options to manage the funds:
Rollovers
- Direct Rollover: You can move the funds directly to your own active 401(k) plan or an Individual Retirement Account (IRA) within 60 days of inheriting the account. This preserves the tax-deferred status of the funds.
- Inherited IRA: You can create an Inherited IRA and roll over the funds into it. Inherited IRAs are subject to the same distribution and tax rules as traditional IRAs.
- Beneficiary IRA: If you are a named beneficiary, you can open a new IRA and inherit the funds into it. This allows you to take distributions as needed without the early withdrawal penalty.
Beneficiary Options
As a beneficiary, you have different options based on your relationship to the deceased:
Beneficiary Relationship Distribution and Tax Options Surviving spouse Can roll over the funds to their own 401(k) or IRA. No change in account ownership or tax basis. Dependent child under 18 Can receive distributions until they reach the age of majority (18-21 depending on state laws).
May need to establish a custodial account.Other beneficiaries (non-spouse, over 18) Must take distributions within a 10-year period as a non-spouse beneficiary.
Funds are taxed at ordinary income rates.Note: It’s important to consult with a financial advisor or tax professional for personalized advice and to fully understand your options before making any decisions about the inherited 401(k).
Estate Planning Considerations
When inheriting a 401(k) from a parent, there are several estate planning considerations to keep in mind:
- Beneficiary Designation: Ensure that you are the designated beneficiary of the 401(k). This can be changed by the account holder at any time.
- Estate Taxes: If the 401(k) is part of the parent’s estate, it may be subject to estate taxes. The estate tax exemption for 2023 is $12.92 million per individual.
- Stretch IRA: Consider establishing a Stretch IRA, which allows you to withdraw funds from the 401(k) over your lifetime. This can minimize taxes and preserve the account’s value.
- Rollover to Own IRA: You can roll over the 401(k) into your own IRA, giving you more control over the investments and distribution options.
- Required Minimum Distributions (RMDs): Once you reach age 72, you will be required to take RMDs from the 401(k). This can trigger income taxes.
Estate Planning Options for 401(k) Inheritances Option Benefits Drawbacks Stretch IRA Minimizes taxes, preserves account value Limited withdrawal flexibility Rollover to Own IRA Increased control, wider investment options Potential for higher RMDs Distribute Outright Immediate access to funds Higher income taxes Hey there, folks! Thanks for sticking with me through this deep dive into the ins and outs of inheriting a 401k from your folks. It can be a bit of a rollercoaster ride, but with careful planning and a little bit of luck, you can make the most of this financial opportunity. Keep checking back for more juicy money talk and remember, if you’ve got any questions, don’t be shy to reach out. Until next time, take care and keep your finances in tip-top shape!