Inherited 401(k) rules: What beneficiaries need to know

Karen Roberts | (TNS) Bankrate.com

If a loved one has named you as a beneficiary of their 401(k), knowing how to make the best use of the bequest is another way to honor them. How to best use an inherited 401(k) depends on a number of factors — first and foremost your relationship with the primary account holder.

Here are the key rules to know when inheriting a 401(k) and how to avoid some major penalties.

What is an inherited 401(k)?

A 401(k) is an employer-sponsored retirement plan that workers can contribute to during their working life. If there’s money left in the account, it can be passed on to heirs, and you can inherit a 401(k) directly from a spouse or any account holder who has listed you as a primary beneficiary or a contingent beneficiary on the account. If listed as a contingent beneficiary, you would inherit the 401(k) if the primary beneficiary has passed away or cannot be located.

This article does not address options for heirs who end up with a retirement account as a result of asset distribution through probate, as different rules apply.

What are the rules when you inherit a 401(k)?

The rules for an inherited 401(k) differ, depending on whether the money was inherited from a spouse or a non-spouse. Depending on your relationship, you’ll have different options for what you can do with the money and how those options affect your tax situation.

Additionally, if you’ve inherited a 401(k) and you’re a minor child, chronically ill or disabled, or not more than 10 years younger than the decedent, you have different distribution rules. You can take distributions based on your own life expectancy and not be subject to the 10-year rule, which is described in further detail below.

Rules and options for distribution when inheriting an account from your spouse

Surviving spouses have four options to consider:

• Take a lump sum distribution: Taking a lump sum distribution will not incur an early withdrawal penalty, but the distribution will be taxed as ordinary income and could put you into a higher tax bracket. Withdrawing the money all at one time is a good option only if you really need to access the full value of the account as quickly as possible.
• Roll the inherited 401(k) directly into your own 401(k) or IRA: This choice gives the inherited money more time to grow. Regular 401(k) rules apply for withdrawals prior to retirement age, meaning you’ll pay a 10% penalty for early withdrawals before age 59 ½. When you reach age 73, you must start making required minimum distributions (RMDs) based on your life expectancy. More can be withdrawn, but never less than the minimum without incurring a penalty. Rollovers do not incur penalties, but you’ll likely owe tax if you convert a traditional 401(k) to a Roth 401(k) or a Roth IRA.
• Transfer the funds directly from the 401(k) account into a new inherited IRA: If you rolled the inherited 401(k) into a new inherited IRA, you are allowed to make withdrawals without incurring an early withdrawal penalty, a move that may be helpful for spouses who have not reached age 59 ½. Inside the inherited IRA, the plan operates according to the distribution rules for inherited IRAs.
• Leave the inherited 401(k) where it is: If you leave the 401(k) in the plan you inherited, you are required to take RMDs based on life expectancy. This method allows you to minimize taxes by withdrawing money over time. If you are over 59 ½ and your spouse was taking RMDs when they passed, you have the option of continuing that payment or delaying it until you reach 73. If you’re already 73, taking RMDs is required. If you are between 59 ½ and 73 and your spouse is not yet 73, you can take RMDs based on when your spouse would have reached RMD age.

For any of these options, if you’re over age 59 ½, you won’t be subject to any penalty tax for early withdrawal.

Rules and options for distribution when inheriting an account from a non-spouse

Non-spousal beneficiaries have three choices, with the associated withdrawal rules below:

• Transfer funds directly from the 401(k) account into an inherited IRA: In an inherited IRA all money must be withdrawn within 10 years. If the money was in a pre-tax 401(k), you’ll owe tax on any withdrawals from the inherited traditional IRA. If you are withdrawing from a Roth 401(k) or converting it into a Roth IRA, there will be no tax implications as the money was contributed on an after-tax basis. If you convert a pre-tax 401(k) into a Roth IRA, you’ll generally owe taxes on the conversion.
• Take a lump sum distribution: This action provides you with immediate access to the money. If you take a lump sum distribution, you may incur hefty taxes, if you realize a significant income or the money may push you into a higher tax bracket. If the inherited 401(k) is pre-tax, you’ll pay taxes at ordinary income rates. If the account is a Roth 401(k), then you won’t owe any income taxes on the withdrawal.
• Leave the money in the 401(k) and withdraw it over 10 years: You can also leave the money in the 401(k) account, but you’ll still need to withdraw it within 10 years, to meet the 401(k)’s 10-year rule.

The 401(k) 10-year rule and how it works

Prior to the passing of the 2019 SECURE Act, non-spouse beneficiaries had more options for the timing of withdrawals, particularly required minimum distributions. Now, most non-spouse beneficiaries have 10 years to deplete the inherited account, called the 10-year rule.

If the account owner died in 2020 or later, non-spouse beneficiaries must withdraw all funds by the end of the 10th year of the account owner’s passing or be subject to a 50% penalty on any remaining account assets. For account owners who passed in 2019 or earlier, beneficiaries also had the option to withdraw all the money by the end of the fifth year from passing. If the account owner passed in 2019 or earlier, RMDs could be based on your life expectancy.

For non-spouse beneficiaries inheriting in 2020 or later, only minor children of the account owner, disabled or chronically ill individuals, or those not more than ten years younger than the account owner at the time of their death can take RMDs based on their life expectancy. Once the minor child reaches the age of maturity based on their own state rules, then the 10-year rule kicks in. The 10-year rule will not kick in for the other two categories of beneficiaries.

Currently, the IRS does not require those subject to the 10-year rule for 401(k)s to take minimum annual distributions. So account owners could wait until the last year and take out the lump sum.

Bottom line

Dealing with an inherited 401(k) can bring a lot of complications, and your choices depend a lot on your relationship to the decedent, your age at inheritance, the account owner’s age when they passed and whether the account you inherited is pre- or post-tax. So it can be valuable to consult with a trusted financial adviser before making any decisions.

(Bankrate’s Rachel Christian contributed to an update of this story.)

(Visit Bankrate online at bankrate.com.)

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