Do beneficiaries pay tax on 401k?

When you inherit a 401(k) from a spouse or parent, there are certain things you should know to avoid costly mistakes. Typically, before making any decisions on how you are going to access the money, you should consider the tax consequences of any decision you make. Tax rules for inherited 401(k)s depend on your relationship with the deceased account owner; there are different rules for spouses and non-spousal beneficiaries.

When you inherit a 401(k) as a beneficiary, you will pay taxes when you take a distribution from the 401(k). Typically, distributions of inherited 401(k) assets are added to the beneficiary’s taxable income for the year. However, distributions from a Roth 401(k) may be tax-free if the account was at least five years old and the original account owner was above 59 ½. 

How inherited 401(k) is taxed

When a person dies, the 401(k) retirement account is considered part of their taxable estate. Therefore, any taxes on contributions or earnings from investments in the 401(k) that were deferred would need to be paid when the original account holder dies. Therefore, when you inherit a 401(k), any distributions you take from the account will be taxed the same as would apply to the original account holder.

If you inherit a traditional 401(k), the distributions you take would be included in your taxable income for the year, and possibly push you to a higher tax bracket. However, if you inherited a Roth 401(k) where the original account holder made after-tax contributions, you may qualify to take tax-free distributions if the Roth 401(k) is at least 5 years old. This means the deceased account holder must have started making contributions to the account at least five years before you made the first withdrawal.

Who Pays Tax on Inherited 401(k)?

When a person dies, the named beneficiaries of the 401(k) plan are entitled to receive any retirement assets remaining in the account.

Generally, the spouse of the deceased person is usually the primary beneficiary and is entitled to receive the 401(k) assets of the original account owner. If the spouse is also deceased or disclaims the inherited assets, the assets will go to the other named beneficiaries, either son, daughter, grandchild, or other relatives of the deceased.

The beneficiaries who inherit the 401(k) assets will owe any unpaid taxes owed on the account. These assets will be taxed at the beneficiary’s tax bracket rate. If you take distributions in a year of high income, the inherited assets will push you to a higher tax bracket.

Spousal Beneficiary Options with Inherited 401(k)

If you were married to the deceased account holder, you have several options with the inherited 401(k) assets. You can choose either of these options:

Leave it

If you don’t need the inherited 401(k) money right away, you can leave it in the inherited 401(k). This allows the money to continue growing until when you decide what to do with the money. You can also take regular distributions from the account, and pay taxes on the amount withdrawn. However, you won’t pay an early withdrawal penalty if you are below age 59 ½. 

Withdraw it

If you need money to meet your everyday expenses or pay medical expenses, you can decide to withdraw funds from the inherited 401(k). You can withdraw the money in one lump sum or in several tranches spread over several years. You will owe taxes on the distributions you take.

Rollover over to inherited IRA

You can rollover the inherited IRA into your own IRA, and remain a beneficiary. Request a trustee-to-trustee rollover to your IRA to avoid creating a taxable event. Once you’ve rolled over, you can start making withdrawals based on your life expectancy.  

Non-Spousal Beneficiary Options with Inherited 401(k)

If you are a non-spousal beneficiary, your options with the inherited 401(k) are limited. The Secures Act of 2019 requires non-spousal to withdraw all retirement assets from the inherited IRA by the 10th anniversary of the account owner’s death. However, minors and beneficiaries who are chronically ill or disabled are exempted from this requirement.

There is no set amount that the beneficiaries must withdraw each year, as long as all assets are withdrawn by the 10th anniversary of the account owner’s death. Any assets that remain in the account by the lapse of the 10 years will be subject to a 50% penalty.

The tax implications of inheriting retirement assets depend on the type of 401(k); traditional 401(k) or Roth 401(k). Distributions from a traditional IRA are taxed at the ordinary income tax rate and could bump you into a higher tax rate. You can spread the distributions over the 10 years to lower the amount of taxes you will owe each year.

For Roth 401(k) withdrawals, the distributions will be tax-free if the account had been open for five years or more. However, if the inherited Roth 401(k) is less than five years old, you will owe taxes on the earnings generated, but the contributions will be still tax-free.