Inherited 401k from parent

Basic Considerations for 401k inheritance

Most wealth managers and financial advisors stress the importance to their clients of developing a lifelong habit to consistently contribute to their 401(k) or other qualified retirement plan (e.g., 403b, 457).  Maximizing an employer match when contributing is especially important to grow your 401(k) tax-deferred into your retirement years.  Many people achieve great success with their contributions, and in some cases leave a large legacy account to their heirs, which can lead to some confusion about the inheritance process.  If you or a loved one has recently learned that a family member is leaving you an inherited 401(k), there are a handful of very important details to work out, to minimize your taxes and maximize your inheritance.

Many people are surprised to learn that the inheritance of a retirement account like a 401(k) or IRA is determined by the beneficiary designation on the account, not on a will.  In other words, the beneficiary that you designated on the plan has the right to inherit that money, even if the will specifies otherwise.  A spouse is the “default” beneficiary, but they can sign a waiver to allow the plan owner to specify another beneficiary, such as a child or a trust.

Inheriting a 401(K)

One of the primary benefits of using a qualified plan like a 401(k) is that usually income taxes have been deferred on retirement plan contributions and earnings. The exception would be in a Roth 401(k), where contributions are not subject to income taxes because the contributions are made with money that has already been taxed.  Most retirees are advised to withdraw from their taxable accounts before their tax deferred accounts, which means that 401(k)’s have a tendency to be inherited.  The beneficiary of course has to pay income taxes on the inherited plan assets, just like the owner had to when they were drawing down the account.  The details can vary dramatically based on who inherits the account (spouse or non-spouse), and whether the owner had begun to take required minimum distributions (RMD).

Spouse Inheritance

A surviving spouse generally has three possible options when their loved one leaves a 401k as part of their estate:

1.)  If their plan administrator allows, they can roll it over into their own employer qualified plan.

2.)  They can roll it over into their own IRA or an inherited IRA.

3.)  Or they can just leave the money in the 401k (if the plan allows).

If the deceased spouse had not yet began taking RMDs, then a surviving spouse under age 70.5 would not have to take RMDs on a 401(k) until they are 70.5.  The RMD’s are mandatory, regardless if the plan is rolled into an IRA or kept in the original 401k.  If the surviving spouse is over age 70.5, they would have to take RMDs whether the money is left in the 401(k) or is rolled over to an IRA.

Non-spouse Inheritance

Non-spouse heirs have similar options, but they cannot move the funds into their own IRA or 401k plan:

1.)  They can roll it over into an inherited IRA

2.)  Or they can just leave the money in the 401k (if the plan allows).

Generally, inherited plans require the distributions to be taken out within 5 years (could be a lump sum as well), or they can institute what’s called a “stretch-out plan”.  In a stretch-out distribution plan, the planned RMD’s are based on your age (and expected life expectancy) and account balance based on a specific set of rules. See here for a RMD calculator to estimate your stretch-out distributions. 

In both options, there will be RMD’s, it’s just that some plans will allow this over the beneficiaries’ lifespan, but others require the process to be complete within 5 years.

Tax Implications

Remember that RMD’s are just required minimums.  You can withdraw the full balance at any time, without penalty, even if you’re below 59.5 (in contrast to the 10% penalty on withdrawing from you’re your own qualified plans).  However, this is rarely the best course of action, because the beneficiary will owe income taxes on everything they withdraw (unless it was a Roth 401k, which has reduced income tax liability).  In many instances, taking the lump sum will also bump the beneficiary to a new tax bracket, increasing their marginal tax rate, and ultimately how much of the inheritance they lose to taxes.  A much better option is to use a stretch-out distribution plan for non-spouses, or to just take the RMD’s after 70.5 for spouses.  In this way, the tax liability is spread out over a much longer time, and the beneficiaries’ marginal tax rate will remain unchanged.

If you would like to learn more, or need help dealing with an inherited 401k or IRA in Oklahoma, please contact us!