How to handle an inherited 401(k)

If you've inherited a 401(k) plan, you need to understand the tax implications. The 401(k) inheritance tax rules vary depending upon factors such as your relationship to the deceased person, when you withdraw money, and your age. When you may—or must—withdraw money from the 401(k) also depends upon the rules of the particular plan.

Plan documents

The inheritance of a 401(k) plan is determined by how the plan was set up by the decedent, or person who has passed away, not by the decedent's will. Unless a spouse signs a waiver, they must be named as the plan holder's beneficiary. If a waiver is signed or the decedent is not married, one or more other individuals can be named as beneficiaries. A trust may also be designated as a beneficiary, in which case the terms of the trust determine the distribution.

Review the 401(k) plan documents to see if the inherited funds must be withdrawn immediately or can be withdrawn in smaller amounts over time. Many plans require a lump-sum withdrawal of the funds so that plan administrators don't have to maintain an account for a beneficiary. However, some plans allow the beneficiary to withdraw the funds over a period of five years or even longer, based upon the beneficiary's life expectancy.

Estate and income taxes

If the value of the decedent's estate exceeds a certain amount, it becomes subject to the federal estate tax, which changes annually. For 2018, the estate must exceed $1.18 million in order for the tax to come into play. For 2019, the estate must exceed $1.4 million. There may also be a state inheritance or estate tax.

Income tax is owed when funds are withdrawn from a 401(k) or an individual retirement account that is not a Roth IRA (individual retirement account). If the plan is a Roth 401(k), different tax rules apply because taxes were paid on the funds before they went into the plan.

For most people, it is advantageous to delay the withdrawal of funds in order to minimize the tax liability. If the 401(k) plan requires a lump-sum withdrawal, the beneficiary is subject to tax on the full amount in the plan. If the plan allows for withdrawal over a five-year period, the tax obligation can be spread out over five years. If the funds can remain in the plan or be rolled over into another plan or an IRA, the tax obligation can be spread out even longer.

Surviving spouse

A surviving spouse may have three options:

1. Leave the funds in the inherited 401(k) plan, if permitted.
2. Roll the funds into their own 401(k), if their plan allows. Ideally, this should be a direct rollover from one 401(k) to another. Any rollover checks must be deposited within 60 days and are subject to Internal Revenue Service (IRS) withholding rules.
3. Roll the funds into an IRA, either your own or an inherited account. Again, this should be done as a direct rollover. If you leave funds in the decedent's plan, the decedent's beneficiary designations apply. If you roll the funds into an inherited IRA or into your own 401(k) or IRA, you can name your own beneficiaries.

A person with a 401(k) or an IRA is required to begin withdrawing funds at age 70 ½. The least amount that must be withdrawn under federal law is called the required minimum distribution (RMD). How this applies to a surviving spouse depends upon the ages of the surviving spouse and the decedent, as well as whether the surviving spouse leaves the funds in the decedent's plan, rolls them over into an inherited IRA, or rolls them over into their own 401(k) or IRA. You may always withdraw more than the applicable RMD.

The analysis is dependent upon whether the decedent had reached age 70 ½. It is also different if the surviving spouse is over age 70 ½, is between the ages of 59 ½ and 70 ½, or is under age 59 ½.

Other beneficiaries

A beneficiary who is not the surviving spouse may have two options:

1. Leave the funds in the inherited 401(k) plan, if permitted.
2. Roll the funds into an inherited IRA. If you leave funds in the decedent's plan, the decedent's beneficiary designations apply. If you roll the funds into an inherited IRA, you can name your own beneficiaries.

As with a surviving spouse, the RMD rules that apply vary depending upon whether the decedent was over or under age 70 ½.

Tax laws are complicated and always subject to change. Consulting with a tax professional can help minimize your tax obligations, especially if the inherited plan contains company stock. In addition to the advice of a tax professional, more information can also be obtained from an online service provider.