The Ultimate Guide to Inherited 401(k)s

The Ultimate Guide to Inherited 401(k)s

July 7, 2023

Tanko Law Montana

So, you find out that you are inheriting a 401k. This is great news! The questions now are: what do you do with it? How can you pay the minimum taxes on the amount left to you? Are there going to be any penalties for withdrawing funds from that account? If so, how much will they be? The questions, it seems, keep steadily increasing.


The associates at Tanko Law are here to help demystify your inherited 401(k). In our Ultimate Guide to Inherited 401(k)s, we’ll help you to navigate these waters and determine a strategy that works best for you.


What is a 401(k)?


A 401(k) account is a popular choice to save for retirement offered by many employers throughout the United States. It allows employees to deduct an amount from their paycheck to set aside for retirement from their pre-tax (gross) income. Frequently, employers also “match” the funds allocated to the 401(k) account by employees by a certain percentage: 50%, 100%, etc. So, if employee Bob puts $6 into his 401(k) every pay cycle and his employer matches 50%, then the actual amount Bob puts into the account is increased by $3. Many employees look at this match as “free money”.


Taxes must eventually be paid on funds in a 401(k) account, however, and they can be considerable, and even include penalties, if the account holder tries to withdraw them early. Many 401(k) accounts also offer employees the option to borrow against their 401(k)s and repay the amount borrowed over time through payroll deductions. Most people plan to use their 401(k)s and exhaust them during their lifetime. Life; however, doesn’t always go to plan.


What is an Inherited 401(k)?


An inherited 401(k) is an employee-sponsored 401(k) retirement account that was left by a person who passed on without spending everything in their 401(k). The person who passed on contributed to their 401(k) throughout their working life. Certain tax and financial laws govern this asset a little differently than others, so it’s important to understand the various options you have as the inheritor.


Different inheritors are designated by the account owner. The 401(k) allows its owner to designate a primary beneficiary (usually their spouse) and contingent beneficiaries (this can be anyone they choose). If the primary beneficiary has passed away or cannot be located, the account is inherited by the contingent beneficiaries. Funds are allocated to beneficiaries based on the account owner’s preferences.


What are your options when you inherit a 401(k)?


The spouse and the contingent beneficiaries have varying options in terms of how they can access the account’s funds. Overall, however, the beneficiaries have the following options:


  • Roll over the money into their own 401(k) (only spouses have this option)
  • Take a lump-sum distribution (get the entire amount of the account paid to you all at once)
  • If the account owner passed in 2019 or before, all of the funds must be withdrawn by the end of five years following the owner’s death (five year rule)
  • If the account owner passed in 2020 or after, all of the funds must be withdrawn by the end of ten years following the owner’s death (ten year rule)
  • Spread the withdrawals out over your lifetime (life expectancy method) by taking the required minimum distributions (RMDs) - this is limited to certain eligible beneficiaries, and applicable only if the owner died in 2020 or later


401(k) Spouse Beneficiary


When the account holder’s spouse inherits their 401(k), they have one option that differs from the rest: the opportunity to roll the money into their own retirement account. This is frequently the most attractive option because it defers all of the taxes on the inherited account to when they begin to draw on their own 401(k), which can be months or even years later. The government basically treats these funds as though they had been in the spouse’s account all along.


The only drawback is that those funds are inaccessible if you are younger than 59 ½, and until you begin to take withdrawals from your own retirement account. If you try to withdraw any of the funds any earlier, you’ll get hit with a 10% early withdrawal penalty and have to pay all of the taxes owed on the funds. 


All of the other methods of withdrawal available to non-spousal, contingent beneficiaries, are also available to spouses, as we’ll discuss in the next section.


Inheriting a 401(k) as a Non-Spouse


As a non-spouse or contingent beneficiary, all of the other options outlined above are available to you. They are also available to the spouse. 


Lump-sum distribution


With a lump-sum distribution, you withdraw all of the money from your inherited 401(k) all at once. This is quite simple and it gives you a large influx of cash, but the taxes on those funds must be paid back within a single year. Typically, you lose more of your inheritance to the government than you would have if you’d used another distribution strategy, but it can be nice to have the option if you’re in need of quick cash.


Five-year rule


If the account holder passed away in 2019 or earlier, the beneficiary can spread out the tax burden and the distribution of funds over five years from their date of death. This can help a beneficiary who is nowhere close to their own retirement maximize the amount of funds they receive and minimize the taxes they must pay. 


Ten-year rule


Like the five-year rule, the ten-year rule gives the beneficiary ten years to withdraw all of the money from the account while paying the minimal possible taxes on those funds. This rule went into effect in 2020, so it doesn’t apply to the account of anyone who passed in 2019 or earlier.


Life Expectancy Method


The life expectancy method requires that you take RMDs -required minimum distributions- out of the account based on your life expectancy. You calculate your life expectancy by dividing the total value of the inherited 401(k) by the distribution period for your age in the IRS Single Life Expectancy Table. For every subsequent year, you subtract one from the distribution period and divide the remaining balance by the number that results. 


This method fully minimizes the amount of taxes you pay on a 401(k) in a year. While this strategy was available to any beneficiary prior to 2020, after 2020 the only beneficiaries who can use this are:


  • Surviving spouses
  • Minor children of the account owner (until they reach the age of majority)
  • Disabled or chronically ill individuals
  • Anyone not more than 10 years younger than the account owner at the time of their death


In fact, not all 401(k) plans allow the use of this method, even if you do qualify for it. You can, however, request that the employer transfer the account funds to an inherited IRA, and then use this approach with the distribution of that account.


Seek Financial Advice


Like many major financial decisions, if you’re determining how to manage a newly-inherited 401(k) it makes sense to enlist financial professionals to guide you through the process. At Tanko Law, our attorneys can help you get the ball rolling on the best possible strategy for your newly-inherited 401(k) account. Contact us today!

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