Have you just lost a loved one and discovered they left you behind their retirement account? Or, as you prepare for your end of life – whenever that may be – maybe you’re wondering if you can leave behind a 401K to your kids or grandchildren. Either way – you want to know all about 401K inheritance. And you’ve come to the right place for that.
Today, we’ll answer a wide variety of questions surrounding the topic of inheriting a 401k. That includes:
- Can a 401K be inherited?
- What happens when you inherit a 401K?
- How much tax on inherited 401K are you responsible for?
- What should I do with a 401L I’ve inherited?
By the end of this article you’ll feel more confident in your next steps after inherting a retirement account or preparing to build out your will. Let’s get right into the first question on today’s agenda – can a 401K be inherited?
Can a 401(k) be Inherited?
Yes! 401(k) plans can be inherited. This happened when the account owner names beneficiaries at the time that they opened their account. The beneficiary is the person that would receive the funds in this account in the event of the account owner’s death. Account owners can specify this information on a 401(k) beneficiary designation form!
If you are a beneficiary, you will need to pick how you want to receive the inherited 401(k) funds. There are a variety of factors that will impact the inherited 401(k) options you have available. Some important factors to keep in mind when it comes to an inherited 401(k) includes:
- The account owner’s age at the time of death
- When the account owner passed away
- The relationship of the beneficiary and the account owner
- What the 401(k) plan allows
- The beneficiary’s health
- The age of the beneficiary
- Life expectancy
- So, yes – a 401k can be inherited. But how does inherited 401K work, exactly?
How Does Inherited 401k Work?
A 401K plan can be inherited by filling out the proper paperwork with the custodian of the account or through beneficiary designations that have been made by the deceased individual prior to their death. It is important to note that assets from these plans must begin to be distributed within five years after the date of death, otherwise they become subject to taxation as ordinary income. Depending on where you live, some states also require that estates pass through probate court before assets can be distributed among beneficiaries.
When it comes to taxes associated with an inherited 401K, there are two primary options available for beneficiaries: 1) take distributions and pay taxes; 2) rollover into an IRA and defer taxes until later in life when tax brackets may be lower.
For most individuals, rolling over will make more sense financially since it allows them to preserve their inheritance for years and not pay taxes on it until they start making withdrawals or transfers from their own IRA accounts.
How Much Tax on Inherited 401k Are You Responsible For?
One of the most common concerns one has after inherting a 401K is how to pay income tax on it. So – how much tax on inherited 401K are you responsible for?
The amount of tax due on an inherited 401K depends on several factors including your age and whether any contributions were made pre- or post-tax over the course of ownership by the original owner of the account.
Generally speaking, though, beneficiaries are responsible for paying income tax at their marginal rate on any withdrawals from an inherited retirement plan such as a 401K or IRA account when taking distributions or cashing out all at once instead of rolling over into another retirement vehicle such as an IRA rollover account for instance.
By keeping their inheritance in a retirement plan, the account holder could reduce taxes significantly. Additionally, if they choose to receive distributions immediately upon inheriting a 401(k) or another type of plan, they would also benefit from compounding interest growth over time rather than cashing out early.
What To Do If You Inherit A 401K?
If you have recently inherited a retirement plan such as a 401k or other savings vehicle then there are several steps you should consider in order to ensure that your inheritance is properly maximized while minimizing potential taxes due during this transition period. While we recommend you consult a professional, here is what to do if you inherit a 401:
- Determine what type of retirement plan has been inherited. This determines eligible options that may be available. While you’re here specifically to learn about inheriting a 401K, this is just one of the many types of retirement accounts that can be inherited
- Research & gather information regarding required documentation needed by (eg., death certificate/will etc.)
- Consider all available options – decide whether it makes more sense to keep money invested in current plan/rollover into another one
- Contact the financial institution handling plan & inquire about fees associated with transferring funds out
- Understand any potential tax liabilities associated with the distribution vs rollover option chosen
- Utilize tools such as calculators & advisors resources provided by many financial institution websites
- Make sure all forms are filled out accurately & thoroughly prior submission
- Monitor progress throughout transfer process & keep informed about potential changes/updates (eg., contribution limits etc.)
- Investigate other potential benefits associated with inheriting retirement plans (eg., spousal rollovers etc.)
- Understand deadlines concerning withdrawal timelines & required minimum distributions
The Danger of Withdrawing a Lump Sum from an Inherited 401k
It can be tempting to withdraw a lump sum from your inherited 401k. But if you find yourself with an inherited IRA then you have some options that you can keep in mind.
While you can cash out the inheritance by taking a lump sum withdrawal, that could push you into a higher income tax bracket which results in more taxes. But again, a professional is always the way to go to find the best way to handle your situation!
Final Thoughts on What to Do With an Inherited 401K
That wraps up our complete guide on what to do with an inherited 401K. We hope this article answered all your questions about inheriting a 401K account in terms of taxation, how the process works, and what you should do next. If not, we recommend you get in touch with a professional you trust and explore the process further.
At this point, you can learn more about 401K accounts in our blog. We have complete guides on if 401Ks are worth it, how 401K matching works, the difference between IRAs and 401Ks, and a whole lot more!