Inheriting a 401k might not be something you’ve planned for, but if it happens, it can be a valuable asset when handled correctly. While a financial windfall such as this can be amazing, an inherited 401K comes with specific rules and tax implications that can get tricky and cause some headaches if you’re not careful.
Whether you’re a spouse, a non-spouse, or even if the account was left to a trust or charity, knowing what you’re allowed (and required) to do can save you from making costly mistakes.
Let’s break down what you need to know, starting with the different types of beneficiaries.
If You’re the Spouse. A Surviving Spouse has the most flexibility and is offered two tax-favorable options.
Option 1. You can roll the 401K into your own retirement account. This is often the best move if you don’t need the money right away. By rolling it into your own IRA, you get to delay Required Minimum Distributions (RMD's) until you hit retirement age (currently that's 73 for most people).
Option 2. Leave it as an inherited IRA. This means the account stays in your late spouse’s name, but you’ll need to start taking RMD's by December 31 of the year after their passing.
A big advantage is you’re allowed to stretch those withdrawals over YOUR life expectancy (not the deceased), potentially helping to lower your tax obligation each year.
If You’re a Non-Spouse. Non-spouse beneficiaries don’t get the same rollover options and advantages. Instead, you’ll typically need to follow the 10 Year Rule, meaning you have to empty the account by the end of the 10th year after the original owner’s death.
Currently, there’s no rule saying you must take distributions every year during that 10-year period, so you could take the full amount immediately or wait until year 10 to take it all at once, however, spreading withdrawals out evenly over time can help manage the overall tax obligations depending on your current and expected income.
Withdrawing everything at once could bump you into recognizing that cash at one of the top tax brackets, significantly cutting into what you would otherwise be able to keep.
Let’s consider this example: Your taxable income was $150,000 for 2024 and you would owe approximately $29,042 in Federal Taxes, falling within the 24% tax bracket. Remember, the 401k withdrawal is treated as ordinary income, so you have the choice to take the inherited 401k withdrawal all at once or over time, with a maximum of 10 years.
Taking a withdrawal of $25,000 per year ($250,000/10 years) would keep you in the same 24% tax bracket. However, withdrawing the entire 401k would force you into the 35% Federal tax bracket.
You could also withdraw a maximum of $41,950 from the 401k for approximately 6 years, still keeping you within the threshold of the 24% tax bracket.
Special Exceptions for Certain Beneficiaries. There are exceptions to the 10 Year Rule for a group called Eligible Designated Beneficiaries (EDB's).
EDB's include minor children of the deceased (until they reach adulthood), disabled individuals, chronically ill individuals, and beneficiaries who are no more than 10 years younger than the account holder.
EDB's can stretch out distributions over their life expectancy instead of sticking to the 10 Year Rule.
If a trust or charity is named as the beneficiary, things may get complicated. Generally, the 10-year rule still applies unless it’s a specific type of trust that allows distributions to stretch over time.
If you’re dealing with a trust or charity inheritance, you may want to consult your Wealth Manager and CPA before making withdrawals or changes of any kind to avoid a costly misstep.
Unlike some other inheritance, all withdrawals from an inherited 401K are taxed as ordinary income. This can be frustrating as the beneficiary trying to mitigate your tax burden, but remember those assets were accumulated pre-tax with the understanding they would be used specifically for the individual's retirement.
Once the account owner passes away, the beneficiary is then recognizing it as ordinary income, even if you plan to save it for your own retirement. In short, as a beneficiary, whatever amount you take out will be added to your taxable income for the year, and taxed at your applicable tax rate.
This ordinary tax treatment also means you are not subject to the early withdrawal penalty normally associated with 401ks distributed before age 59 ½. No matter your age as a beneficiary, you simply have the 10 years (or longer if you qualify) to withdraw.
Now that you’ve inherited a 401K, you may want to seek professional guidance on how to handle it, but here are just a few strategies you may want to consider to help keep the taxes in-check, and hopefully keep more money in your pocket.
Inheriting a 401K can be a blessing, but it’s not without it's frustrations and challenges.
The rules and taxes can vary depending on who you are and how you choose to handle the account. Working with a firm that not only has the capability, but also the understanding, to run long-term tax projections is definitely something you should consider.
Whether you’re a surviving spouse looking to roll it over, or a non-spouse figuring out how to deal with the 10-year rule, knowing your options can help you avoid costly mistakes.