What to do with inherited 401k from parents?

If you are a named beneficiary of a deceased 401(k) account owner, you may inherit part of their 401(k) assets. However, inheriting these assets is not a straightforward process, and you will have to understand certain rules provided by the IRS to avoid making costly mistakes. These rules determine what you can do with the inherited 401(k), and the amount of tax you will owe.

You can leave the inherited 401(k) account in the plan, and start taking distributions. You must take the full payout from the inherited 401(k) in 10 years from the account owner’s death. You can also rollover the inherited 401(k) into an inherited IRA. If the parent was already taking the required minimum distributions, you must continue taking the distributions from the account.

What happens when you inherit 401(k)?

When you open a 401(k), you must name the beneficiaries who will receive your retirement savings when you die. The list of beneficiaries is included in the beneficiary designation form and may include spousal and non-spousal beneficiaries. If the account owner was married, the spouse becomes the beneficiary and will receive the 401(k) assets after the account owner's death. However, if the spouse is deceased or has opted out of the inheritance, the 401(k) assets are transferred to contingent beneficiaries.

If you inherit another person’s 401(k), you must first review the plan’s summary plan description to know the rules that apply to your situation. The IRS sets certain limits on inherited 401(k) assets, but 401(k) plans may be more restrictive than the framework provided by the IRS. Depending on your relationship with the account owner, you may have several options with the money. 

Inherited 401(k) Distribution Options for a Non-Spousal Beneficiary

The distributions rules for non-spousal beneficiaries changed after the SECURE Act came into effect. What you do with the inherited 401(k) depends on how old the account owner was when you inherited their retirement assets.

Non-spousal beneficiaries have the following options:

Rollover to an Inherited IRA

Non-spousal beneficiaries can rollover inherited assets to an inherited IRA. You can then take distributions based on your life expectancy and not the account owner’s life expectancy.

Take Required Minimum Distributions

If the account owner had already started taking distributions at the time of their death, you must continue taking these distributions. You can decide to take more than the required distributions, but you cannot take less than the assessed RMD. You can take these distributions based on the account owner's life expectancy, or your own life expectancy table. You can choose to take the minimum distributions if you leave the money in the inherited 401(k) or rollover to an inherited IRA.

Withdraw funds at the end of 10 years of owner’s death

If you are a non-spouse beneficiary, you can leave the retirement savings in the inherited 401(k) and take all the money by the end of the 10 years after the account owner’s death. You can withdraw money at any time, but you must withdraw all the inherited assets by the end of the 10th year. This option helps spread the tax liability over several years.

There are certain situations when beneficiaries are exempted from the 10-year rule. If the beneficiary is a minor, the 10-year rule does not apply until the minor attains the age of majority. Also, if the beneficiary is disabled or chronically ill, they are allowed to spread the distributions over their lifetime under the old distribution rules that existed before the Secure Act came into effect.

Inherited 401(k) Distribution Options for a Spousal Beneficiary

As a spousal beneficiary of a 401(k), you have the following options with the inherited retirement assets:

Rollover to your IRA

As the spouse of the deceased account owner, you can rollover the inherited 401(k) into your IRA. This option involves moving the retirement savings from the 401(k) into an IRA where the funds will continue growing before you decide to take distributions.

If you are below age 59 ½ when you rollover, any withdrawal you make will be considered a taxable distribution, and you will pay taxes on the full amount and a 10% penalty tax for early distribution. If you are above 59 ½, you won’t pay the 10% early distribution penalty. If you have reached 70 ½, you must start taking the required minimum distributions.

Rollover to inherited IRA

You can decide to rollover the inherited 401(k) into an inherited IRA, which is a retirement account designed to hold rollover funds from an inherited account. You can then withdraw funds from the account at any time. If you decide to take RMDs, the distributions will be calculated based on your life expectancy.

Leave money in the plan

If you don’t need the funds immediately, you can leave the 401(k) in the plan. You can then take distributions from the account without triggering the 10% penalty for early withdrawals. If your spouse was already taking RMDs, you must continue taking the mandatory minimum distributions.