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Inheriting a 401(k): How to Manage the Assets

Learn how to handle the inheritance of a 401(k) plan as the options may vary from case to case based on the age of the owner, the beneficiary, and taxes.

Inheriting a 401(k) often comes at an unfortunate time. Someone close to you usually passed away.

As a result:

You’re inheriting their retirement account.

It is imperative you make prudent decisions on what to do with your deceased loved one’s 401(k).

The rules covering 401(k) inheritances can be complicated. This is especially true if you don’t have a good grip on taxes and retirement plans. 

The rules can be vary depending on:

  • who inherited a 401(k)
  • the age of the person who passed away
  • the rules of the specific 401(k) plan where the money is held

Start By Consulting a Fiduciary Professional

Even if you think you understand these rules perfectly, it often makes sense to get a second opinion from a professional.

Once you make a decision, it could have enormous tax consequences.

That could result in paying more tax than you may otherwise have to.

When visiting a professional, make sure you speak with a fiduciary.

Ideally:

You’ll want to talk to someone that charges an hourly rate rather than someone that charges fees based on assets under management or someone that earns commissions. 

Financial advisors that charge hourly for their services have no incentive to get you to roll over the 401(k). 

Advisors that charge assets under management or earn commissions could earn quite a bit of money by convincing you to roll the 401(k) over to them even if it isn’t in your best interests.

Make sure the professional understands the tax implications for your specific tax situation. You may want to check with your tax professional, as well, to make sure everything will work as expected.

Smart financial planning on how to take the account balance could save you a ton of money on taxes. 

The below discusses the high-level options available to you.

There are many detailed rules that are beyond the scope of this article that should be discussed with your financial professional.

Who Can Inherit a 401(k)?

Typically, a 401(k) will usually pass on to the spouse after death. 

Notably:

To pass a 401(k) to someone other than the spouse, the spouse has to sign a form consenting to this. If they do, a different beneficiary can be assigned 

What may surprise some people is the 401(k) will not typically pass on to the person listed to receive assets in a will. 

If there is no beneficiary listed on your 401(k) it is possible your will or your state law will determine who will receive your 401(k).

Options for Inherited 401(k) Money

Once you understand who inherits the deceased person’s 401(k), it’s time to figure out what options that person has. 

Find out the 401(k) Plan sponsor’s rules

Each 401(k) plan sponsor runs its 401(k) in different ways.

While they must follow certain rules, 401(k) plan sponsors can offer different options for what happens with an inherited 401(k). 

Some may require you to take the money out in a lump sum. Others will allow you to leave the money in the 401(k). 

Your first step should be to ask the 401(k) plan sponsor what their rules are. This allows you to figure out what options you have. 

Based on their rules, here are many of the common options you may have:

1. A Lump-sum distribution

One of the easiest options is taking a lump-sum distribution of the full amount out of the inherited 401(k).

This will give you access to the money quickly, but it may result in you paying more taxes.

The more money in the inherited 401(k), the better chance it has of pushing the income into a higher tax bracket

Since a 401(k) allows the original owner to put the money in tax-free, you have to pay taxes on the money when you take it out.

3. Paid out over five (5) years

This option is only available if the original owner had not yet turned 70½ years old yet.

In this case:

Beneficiaries can keep the money in the 401(k) account for up to five years after the original owner passed away. 

By the end of the five years, all of the money must have been distributed if you use this option.

This choice gives you more options for when you take the money out to lower your tax burden. 

  • You can take more money out in years where you have less income.
  • You can also take out less money if you’re having a year with a rather high income. 

The key is making sure all of the money is taken out before the five year period is over.

4. Take minimum annual withdrawals

Some 401(k) plans allow you to leave money in the plan and use a stretch option. 

If the deceased person was over age 70 and ½ and had started taking required minimum distributions before they died, you must continue taking out required minimum distributions

The stretch option allows you to take minimum distributions based on the longer of (according to the IRS):

  • your life expectancy
  • the original owner’s life expectancy

You can always take out more than the minimum required, but never less.

If the deceased person had not yet reached age 70 and ½, you have the option to start taking RMDs based on your life expectancy.

This method can be extremely beneficial.

It essentially requires you to take out the least amount of money possible each year.

Then, you can leave the money invested and continue to watch it grow in a tax-advantaged account.

By stretching the distributions, you also spread out the income tax hit. The smaller annual distributions won’t likely increase your income as much as a lump sum or five-year distribution would. 

This means:

You can keep the income in lower tax brackets and pay less income tax each year as you slowly distribute the money.

When using the stretch option, you need to be extremely careful. You must always take out at least the required minimum distributions.

If you make an error and don’t take out enough money, penalties may be imposed.

5. Roll over to an inherited IRA

Not all 401(k)s will allow you to use the stretch option. If the 401(k) plan doesn’t, you may be able to initiate a trustee-to-trustee transfer to an inherited IRA

Once the money is in the inherited IRA, you can stretch out the payments in a similar manner. This also uses the required minimum distributions based on your life expectancy.

Even if you do have the option of leaving the money in the 401(k), it may still make sense to convert it to an inherited IRA.

Each 401(k) plan has different investment options. They also have different fee structures and management fees for the investments they offer.

If the 401(k) plan doesn’t offer good investment options or has high fees, transferring the money to an inherited IRA may be more beneficial. 

If you plan to let the money grow, higher fees could take a big chunk out of your future expected returns.

Similarly, expensive investment options or a lack of good investment options could hamper growth.

6. Additional option for surviving spouse beneficiary

As a surviving spouse, you can also continue taking required minimum distributions based on the original owner’s life expectancy.

This could be useful if your spouse was younger than you.

If you’re a surviving spouse receiving an inherited retirement 401(k) account, you can also treat the money as if it was your own. You can roll over the 401(k) into an IRA in your name rather than an inherited IRA account. 

When you roll the 401(k) into an IRA in your name, you no longer have to follow rules based on your deceased spouse’s age and required minimum distributions.

Now:

The money in the account follows the IRA rules as if it had always been in your name.

If you’re under age 59 and ½, the downside to this is that you'll have to pay a 10% penalty for early withdrawals if you take the money out before you turn 59 and ½.

Make Sure You’re Making Decisions With a Clear Mind

When a loved one passes away, the last thing you want to do is deal with financial tasks.

Some people prefer to choose the easiest option just to get it over with. However, it is important to deal with these tasks with a clear mind.

The original account owner would have wanted you to make smart money decisions with the money they have left you.

Don’t take the easy way out.

Take the time to consult a financial professional and a tax advisor to make the most of the money your loved one left you.