Inheriting a 401(k) isn’t quite as simple as inheriting a pricey piece of jewelry or even a money. There are taxation rules and other guidelines that beneficiaries must follow, as well as other considerations to keep in mind when managing an inherited 401(k).
For those who inherit 401(k)s, a first move might be to look over the documents and speak with a tax professional before making any decisions on what to do with the account. It’s important to note that there are various types of 401(k) plans—including traditional 401(k) plans, safe harbor 401(k) plans, and SIMPLE 401(k) plans)—each of which may have slightly different rules and guidelines that govern them.
Here are some rules and guidelines for individuals who have inherited a 401(k) account.
Options For Spouses Inheriting a 401(k) Account
Generally, the way an inherited 401(k) is treated depends on the beneficiary’s relationship to the account holder.
For spouses who inherit a 401(k) from their deceased spouse, they can usually select between a few options for managing the account, including:
• Keep the account where it is. To keep the inherited 401(k) account where it is with the current employer, the beneficiary must check with the plan administrator to verify the rules. Not all plans allow beneficiaries to keep accounts where they are. The account will continue to be subject to maintenance or other fees determined by the employer.
• Roll the account into their own 401(k) plan. If a beneficiary is currently working, the plan may allow the beneficiary to roll the inherited 401(k) into their 401(k). This allows them to manage the inherited funds in the same way they’ve been managing their own investments.
• Roll the account into an IRA. A beneficiary might be able to roll the inherited 401(k) into their own IRA or an inherited IRA (also known as a beneficiary IRA). If the surviving spouse decides to roll the 401(k) into their own IRA, they may have more flexibility with the investment options they select. Additionally, as the account owner, they can continue to make contributions to the account, and required minimum distributions (RMDs) will be based on their age instead of the age of the deceased.
• Take a lump-sum distribution from the account. This option might make more sense if the surviving spouse is over age 59 ½. IRS rules state that if an account holder is under 59 ½, they must pay a 10% early withdrawal penalty (with some exceptions) in addition to income taxes on any distributions (based on the surviving spouse’s income).
Options For Non-Spouses Inheriting a 401(k)
Individuals who have inherited a 401(k) from someone other than their spouse do not have the opportunity to roll the inherited 401(k) account into their own. The impact of this is that the beneficiary cannot contribute to the account once it’s inherited.
These are the options that are open to non-spouse beneficiaries:
• Leave the funds in the account. Beneficiaries do not have to pay taxes on the account’s funds until a distribution is made. It’s important to note that “non-eligible designated beneficiaries” may have to take the money out within 10 years of the account owner’s death. (More on that in the next section.)
• Roll the 401(k) to an inherited IRA. If a non-spousal beneficiary wants to roll over the funds to a new IRA, the original account owner must be listed as the deceased on the inherited IRA account. A beneficiary cannot make additional contributions to an inherited IRA.
• Take a lump-sum distribution from the 401(k) account. As is generally true of 401(k) distributions, beneficiaries should expect the withdrawal to be taxed.
How RMDs Impact Inherited 401(k)s
Depending on the age of the deceased, beneficiaries may have to begin taking required minimum distributions (RMDs) upon inheriting the 401(k) account. This means they will be required to withdraw at least a certain amount of money from the account on a regular basis, whether or not they want to or feel the need to at the current time.
Typically, if the original owner of the 401(k) account died before January 1st, 2020, beneficiaries would use the Single Life Table to calculate RMD amounts. The Single Life Table bases the original account holder’s life expectancy on the age they would be if they were alive. This number helps determine the right RMD amount the beneficiary must take.
The 401(k) plan document will establish the RMD rules for that specific account. The plan administrator of the 401(k) account will guide the beneficiary to the options available for distributions. Pay-out periods can range from anywhere between 5 years to as long as the life expectancy of the beneficiary.
Typically, if the original account owner died after December 31, 2019, The SECURE Act (also known as the “Setting Every Community Up for Retirement Enhancement Act of 2019”) outlines different withdrawal rules for those who are defined as eligible designated beneficiaries and other beneficiaries.
To be an eligible designated beneficiaries, an individual must meet one of the following criteria:
• Surviving spouse
• More than 10 years younger than the original account holder
• Chronically ill
• Minor child
Individuals who are not eligible designated beneficiaries must distribute the entire account by December 31st on the 10th year of the account owner’s death.
Eligible designated beneficiaries are exempt from the 10-year rule: With the exception of minor children, they can take distributions over their life expectancy. Minor children must take any remaining distributions 10 years after their 18th birthday.
Inheriting a 401(k) can be a wonderful and sometimes unexpected financial gift. For anyone who inherits a 401(k)—spouse or otherwise—it can be helpful to review the options for what to do with the account, in addition to the rules that come with each choice.
Some beneficiaries might find it helpful to consult with a financial advisor who can explain each option’s tax implications and financial impact for an inherited 401(k). This could help avoid a massive tax burden and get the beneficiary one step closer to their financial goals.
Need help rolling over an inherited 401(k) into a new retirement account? SoFi Invest® can be of service, helping members invest their money in accordance with their personal goals and risk tolerance.
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