Most workers participating in a 401(k) plan attempt to salt away as much of their income as possible into the retirement plan; at minimum, they save enough to earn the company's match. Hopefully, the nest egg is sufficient to maintain a comfortable retirement.
In many instances, however, people accumulate more money than is necessary for retirement before passing away. In these circumstances, the account owner's beneficiary receives the remaining funds in an inherited 401(k).
Funds invested into a 401(k) usually grow tax-deferred, meaning the contributions reduce the participant's taxable income for the year. Still, then the employee owes taxes on the distributions much later when the funds are withdrawn in retirement. If the account owner dies without paying taxes on their savings, the 401(k) beneficiary becomes responsible for paying the taxes instead.
Beneficiaries must pay income tax on the amount they inherit (in addition to any estate tax owed). However, different strategies can be employed to spread out or delay the tax burden, especially for the spouse of the account's original owner.
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.
The IRS establishes the outside limits of what 401(k) administrators may do when an employee or retiree passes away before spending all the funds in a 401(k) or rolling it over into an IRA. Still, a 401(k) plan administrator can set more restrictive rules than that general framework. 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account for years without touching it (or paying taxes on it), but the plan rules may stipulate that the funds must be withdrawn sooner (or require the beneficiary to take a lump sum).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 tax professional for help, as this can be complicated.
Inherited 401(k) Distribution Options
1. Roll the money into your 401(k) or IRA (this only applies to spouses).
2. Request a lump-sum distribution
3. Withdraw the funds by the end of 10 years following the owner's death.
4. Spread the withdrawals over your lifetime by taking annual required minimum
distributions (RMDs). This option is now limited to particular eligible beneficiaries.
Rolling the 401(k) Funds Into Your Own Retirement Account (Spouses)
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). The U.S. government considers the rollover of spouses' inherited 401(k) accounts as their money all alone. 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 also has the prerequisite of rolling 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. Requesting the plan sponsor (employer) to transfer the money directly (a direct rollover) to the financial institution that manages your IRA is preferable.
If you receive the check, 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.
Lump-Sum Distribution
Many 401(k) administrators will close out the deceased employee's account, sell the 401(k) investments, 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 or the deceased person is under 59½ (the age at which account holders can start withdrawing money from their accounts without a penalty).
Ten-Year Rule
The 10-year rule allows beneficiaries to withdraw money whenever needed as long as all the funds are taken out from the inherited 401(k) by the end of the 10th year after the account owner's passing.
The strategy gives the beneficiary more flexibility when deciding the best time to withdraw the money and can help spread the tax liability over a decade. Suppose the beneficiary is not the original account holder's spouse. In that case, the 10-year rule is probably the preferred method for withdrawing funds from a 401(k) after the federal government tightened restrictions on the life expectancy method for account owners who died in 2021 and later.
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.
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.
Conclusion
When a loved one passes away, deciding the best method to manage an inherited 401(k) 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 inherited 401(k), so it's important to deliberate the pros and cons of your options.
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The information contained herein is intended for educational purposes only and is not exhaustive. Diversification or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. Historical discussions 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. 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 situation.
This content was not reviewed by FINRA.
[1] Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs).
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