20 Sep Inherited 401(K): A guide for Beneficiaries
You just inherited a 401(k). Now what?
There are countless emotions and decisions to make following the loss of a loved one. Thinking through IRS rules on your inheritance is far down the list, but when the time comes, it’s essential to know your options and the lingering tax impact.
For those inheriting a 401(k) or other retirement plan, we hope to provide some essential background on the rules, distribution options, and tax impact of managing this new account.
Some Ground Rules
The first thing to know is that a beneficiary generally will not be obligated to wait until probate is completed to receive the 401(k) account balance.
For example, the IRS rules may permit the beneficiary to leave the 401(k) inheritance in the account for years without touching it (or paying taxes on it). Still, the plan rules may stipulate that the funds must be withdrawn sooner (or require the beneficiary to take a lump sum).
A beneficiary of a 401(k) account should first read the plan document or summary plan description of the plan to determine what rules will apply in this situation. It may be prudent to ask a financial advisor and tax professional for help, as this can be complicated.
Inherited 401(k) Distribution Options
- Roll the money into your own 401(k) or IRA (this only applies to spouses).
- Withdraw the funds by the end of 10 years following the owner’s death.
- Spread the distributions over your lifetime by taking annual required minimum distributions (RMDs). This option is now limited to certain eligible beneficiaries.
- Request a lump-sum distribution
Rolling the 401(k) Funds into Your Own Retirement Account
Many spouses prefer this strategy because it allows them to delay paying taxes on the inherited 401(k) funds until they begin withdrawing money after retiring (assuming they are still working). Once the spouses roll over the inherited 401(k) into their account, the government considers it as if it had been their money all along. Consequently, the funds can continue to grow tax-free for months or years until they must be withdrawn, i.e., because of required minimum distributions (RMDs). Only then does the spouse begin to pay taxes on the inherited funds.
There is an important caveat to this strategy. After completing the rollover, you cannot withdraw money from your newly combined account if you are younger than 59 without paying a 10% early withdrawal penalty and taxes. This approach may not be optimal if you have an immediate need for funds.
A spouse can also roll over the money from the inherited 401(k) into an IRA. The strategy enables the spouse to avoid paying taxes until withdrawing funds from their IRA. It’s preferable to request the plan sponsor (employer) to transfer the money directly (a direct rollover) to the financial institution that manages the account.
If you receive the check (a non-direct rollover), things become more complicated because the employer must withhold 20% for the IRS, and you must remember to deposit the check in your IRA within 60 days. If not, the entire amount transferred will be taxed.
Ten-Year Rule
The ten-year rule allows beneficiaries to withdraw money whenever needed but requires all funds are taken out from the inherited 401(k) by the end of the 10th year after the account owner’s passing. This rule became law in 2021 and may apply to you depending on your relationship with the account owner and whether they were taking distributions. You may also have the option of electing either this option or taking distributions over your lifetime.
This rule is still fairly new, and interpretation is ongoing. We suggest speaking to a CPA or an advisor to help you assess this option.
Life Expectancy Method
The life expectancy method requires the beneficiary to take RMDs from the account based on the beneficiary’s life expectancy. Life expectancy is calculated by dividing the total value of the inherited 401(k) by the distribution period next to your age in the IRS Single Life Expectancy Table.[1] For every subsequent year, you subtract one from the distribution period and divide the remaining balance by this new number.
For account owners who passed away in 2021 and later, only these individuals are allowed to employ the life expectancy method:
- Surviving spouses
- Minor children of the account owner (only until they reach the age of majority)
- Disabled or chronically ill individuals
- Anyone who is not more than ten years younger than the account owner at the time of the death.
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This strategy was prevalent (the use of this method is now limited) because it enabled the beneficiary to spread your withdrawals over decades. Thus, it can also minimize the effect the inherited 401(k) funds have on the beneficiary’s taxes in a given year. The beneficiary can withdraw more money than the RMD if necessary, but they are not obligated to do so.
[1] Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs).
Lump-Sum Distribution
Many 401(k) administrators can close out the deceased employee’s account, sell the investments in the 401(k), and send the proceeds to the beneficiary in a lump sum.
The lump-sum received by the beneficiary will be subject to local, state, and federal income tax. In these cases, however, the beneficiary will not be responsible for the 10% early withdrawal tax, even if the beneficiary and the deceased person are under 59½ (the age at which account holders can start withdrawing money from their accounts without a penalty).
Conclusion
When a loved one passes away, deciding the best method to manage an inherited retirement account may not be a top priority. Nevertheless, reviewing your options is crucial once you are ready to administer the details of your inheritance.
Your decision will significantly impact your taxes and, ultimately, the amount you withdraw from the account, so it’s important to deliberate the pros and cons of your options and seek the advice of an experienced advisor.
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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable, but is not guaranteed or warranted by Mercer Advisors. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation. All investing involves risk, including the possible loss of principal.
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