401(k) Tips

Can 401k be inherited?

Yes, a 401(k) can be inherited, but there are certain rules that you must observe as a 401(k) beneficiary. Here is everything you need to know.

2 min read

Losing a loved one is difficult, and dealing with the emotional and logistical aftermath can take a toll on you. While it may be difficult to deal with the finances during this period, there are certain things you should know if you are a beneficiary of the deceased’s 401(k) account. Knowing what to do with the inherited 401(k) and when to take the money is necessary for tax planning, and it can save you huge tax bills.

If you are a named beneficiary of a 401(k) account, you can inherit the 401(k) money from the original 401(k) owner when he/she has passed on. The primary beneficiary, most often the spouse if the 401(k) holder was married, receives the retirement money if he/she is alive. However, if the spouse has passed on or disclaims the money, the 401(k) money goes to the contingent beneficiaries, who can be a child, close friends, or other relatives who are listed in the 401(k) plan as beneficiaries. If there are no surviving 401(k) beneficiaries, the 401(k) is considered to be part of the deceased's estate and distributed according to the instructions contained in the will.

What is an inherited 401(k)?

An inherited 401(k) is a 401(k) account that is passed on to a named beneficiary upon the death of the 401(k) account owner. In most cases, the inheritor of a 401(k) is usually the spouse if the account owner was married. The spouse becomes the primary beneficiary, and they get to inherit all the money left in the 401(k) account.

However, there are instances when the spouse signs a waiver to reject the inherited money. When this happens, the 401(k) money goes to a contingent beneficiary, who can be an immediate family member, friend, trust, or charity. As a beneficiary, you must decide how to receive the money from the retirement plan. Some of the factors that determine how you receive the money include the 401(k) owner’s age at death, your current age, and your relationship with the original account owner.

Inheriting 401(k) as a Spouse

If you are a spousal beneficiary of the 401(k) account owner, you have several options with the inherited 401(k) money. These options include:

Leave the money in the 401(k) plan

If you are below age 59 ½, you can leave the inherited 401(k) in the plan and make a withdrawal. You will not pay a 10% early withdrawal penalty, but you will owe income tax on the distribution. If your spouse was already taking the required minimum distributions (RMDs) or was 70 ½ when he/she passed on, you would have to continue taking the RMDs.

Transfer Money to Your IRA

If you have an IRA, you can rollover the inherited 401(k) in the IRA. If you are under 59 ½ when you rollover the funds, the transfer will be considered a withdrawal, and you will pay income taxes on the distribution and a 10% penalty tax for early withdrawal. If you are over 59 ½ but below 72, you will not be required to pay penalties on the rollover amount.

If your spouse was already taking RMDs from the 401(k), you can opt to continue taking the distributions, or delay taking the distributions until you attain RMD age. However, if you have reached age 72, you will be required to start taking mandatory distributions based on the Uniform Lifetime Table.

Transfer Money to an Inherited IRA

You can also transfer the money to an inherited IRA, which is designed to hold rollover funds from a 401(k) or other type of retirement accounts. You can take a distribution from the inherited IRA without paying penalties even if you have not attained age 59 ½. An inherited IRA requires you to take distributions based on your life expectancy.

Inheriting 401(k) as a Non-Spouse

When the Secure Act came into effect at the start of 2020, non-spousal beneficiaries of a 401(k) account were required to take full payouts within 10 years of the account owner's death. This means that a 401(k) beneficiary has up to 10 years from the year of death of the account owner to deplete the account.

There are certain exemptions to the 10 year rule i.e. minors, disabled or chronically ill beneficiaries, and spouses who are not more than 10 years younger. Minors must first attain the age of majority for the 10-years rule to take effect. Beneficiaries who are disabled or chronically ill may be allowed to stretch the distributions from the inherited 401(k) over their lifetime. Spouses who are no more than 10 years younger than the 401(k) account owner are also allowed to take distributions from the retirement account under the old rules before the Secure Act came into effect.

If the account owner was below 70 ½ at the time of death, the 401(k) plan may require you to take the distributions over a 5-year period, or spread over the distributions over your lifetime. If you opt for the five-year period, you will be required to withdraw all the money in the inherited 401(k) account within five years of the account owner's passing.

How Inherited 401(k) is taxed

Inherited 401(k)s follow the same tax rules as the original 401(k) account owner. When you take a distribution from an inherited 401(k), the amount will be included in your taxable income for the year, and you will be taxed at your tax bracket. This applies to 401(k)s with pre-tax contributions where the 401(k) account owner did not pay taxes on the contributions.

However, if you inherited a Roth 401(k), you will not owe income taxes on the distributions since this account is funded with post-tax dollars, meaning that the original account owner paid income taxes on contributions. However, five years must have elapsed since the account owner started making contributions to the Roth 401(k) account to qualify for tax-free distributions.