Can a 401(k) be Inherited

In the best case scenario, a person will save just the right amount of money for retirement before they pass away. However, life isn’t perfect so it doesn’t always happen that way. Instead, sometimes a person can pass away when they still have funds left in their retirement account like a 401(k) account or an IRA. In the event of the account owner’s death, those that inherit this account may not know what to do. However, there are tax implications and other things to keep in mind. That is why it’s important to start with the basics.

What are 401(k) Plans?

Before learning about an inherited 401(k), you want to make sure you have the base understanding of a normal 401(k). A 401(k) Plan is an opportunity that employers offer to their employees. Employees don’t have to take advantage of the option if it’s available but many do. That’s because it is a type of retirement investment account that helps people save money towards retirement. It is important to keep in mind that each employer will offer their own version of a 401(k) plan. That means that employees may have limited investment options that they can put their investment funds towards.

Even though these plans offer a lot of benefits there are also limitations to be aware of. Some of the limitations include the fact that there are contribution limits. In 2021 the contribution limits for a 401(k) were:

  • $19,500 for people under 50 years old
  • $26,000 for people over 50 years old

However, contribution limits can change every year. That means it is important to stay up to date with the rules around these plans! The contribution limits for 2022 were:

  • $20,500 for people under 50 years old
  • $27,000 for people over 50 years old

Different Types of 401(k) Accounts

Besides limitations in place that you will want to keep in mind, you will also want to keep in mind that there are two main types of 401(k) accounts. Which are:

  • Traditional 401(k)s
  • Roth 401(k)s

Understanding Traditional 401(k) Plans

Most people think of traditional 401(k)s when they think of this account option. So let’s take a look at what to know about these types of accounts. When people make deposits into these accounts (known as contributions) they will use pre-tax funds. That means that the funds that go into these accounts have not been taxed. Since these funds are pre-tax, that means employees can get a tax benefit right away!

The contributions they put into their 401(k) plan can be considered a tax deduction. Why is that important? Well this tax deduction can reduce the taxable income of the employee. For example, let’s say an employee contributes $3,000. In that same year, their taxable income was $47,000. They can use their $3,000 as a tax deduction and reduce their taxable income down to $44,000. This reduces how much you pay on taxes since it’s a reduced amount!

However, since the tax benefits come right away, that means they won’t last forever. When you take a distribution out of this account you can expect to pay the ordinary income tax rate on the distribution. The funds you take out are known as distributions. However, there are exceptions to this rule. For example if you were born before January 2nd, 1936 and choose to take a lump sum distribution then that would be an exception.

It’s also important to note that besides contribution limits that come along with this 401(k) plan option, there are other rules to be mindful of. Another important rule is the fact that a 401(k) has required minimum distributions (RMDs). These RMDs require the account holder to begin taking distributions out of the account once they are at least 72 years old.

Understanding Roth 401(k) Plans

Besides Traditional 401(k)s another option to consider is a Roth 401(k). This type of 401(k) is a bit different from a Traditional 401(k). That’s because these accounts are funded with after-tax funds. That means by the time the contribution is in the account, taxes have already been applied to that money. While that means people will not be able to claim the contributions as a tax deduction, there are still tax benefits.

Instead, tax benefits will be seen when it’s time to take out a distribution. That’s because the funds you take out will not face any additional taxes. It’s also important to note that besides contribution limits that come along with this 401(k) plan option, there are other rules to be mindful of. Some other important rules are around the distributions for this type of account. There are rules around distributions for these accounts! Only certain distributions are actually qualifying. In order for a distribution to be qualifying it must:

  • Have had 5 years pass since the account holder opened and deposited funds into their account
  • Be taken out by an account holder that is at least 59 and ½ years old at the time of the distributions

Besides these rules this type of 401(k) also has required minimum distributions (RMDs). These RMDs require the account holder to begin taking distributions out of the account once they are at least 72 years old.

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

Inherited 401(k) Distributions

When it comes to available inherited 401(k) distribution options, there are a lot of possibilities. Some inherited 401(k) options include:

  • Roll the funds into your own retirement account
  • Take out a lump sum distribution
  • Take out all funds no more than 5 years after the account holder’s death (if they passed away before 2021)
  • Withdraw all funds no more than 10 years after the account holder’s death (if they passed away after 2021)
  • Take out withdrawals over the course of your lifetime through annual required minimum distributions (RMDs). Life expectancy is a factor of this!

401(k) Alternatives

Besides 401(k) plans, there are other retirement accounts for people to consider. Another popular option is an Individual Retirement Account (IRA). IRAs are another retirement opportunity to consider. However, unlike 401(k) plans, they are not offered by an employer. Just like 401(k) plans, there are two types of accounts that you can choose from. There is a:

These accounts also have contribution limits as well. However, they are much less than a 401(k) account. For 2021 and 2022, the IRA contribution limit is:

  • $6,000 for individuals under 50 years old
  • $7,000 for individuals over 50 years old

What is a Traditional IRA?

A Traditional IRA uses pre-tax funds just like a Traditional 401(k). That means that individuals have the opportunity to get the tax benefit right away. That’s because they can consider their contribution as a tax deduction. This tax deduction would reduce the individual’s taxable income. For example, let’s say a person made a $1,500 contribution to their Traditional IRA. In that same year they had an annual salary of $35,000. They can use their contribution tax deduction and reduce their taxable income down to $33,500. This means the person would only need to pay taxes on that amount even though they made $35,000!

Since a person will see the tax benefit right away, that means it will be different when it comes time to take out a distribution. A person should expect to see the distributions they take out be taxed at the standard income tax rate.

What is a Roth IRA?

On the other hand, a Roth IRA will be funded with after-tax funds. That means that the funds in these accounts have already had taxes applied to them. Even though a person will not be able to see tax benefits right away, they will see them down the line. That’s because when it comes time to take a withdrawal, eligible distributions will be tax-free!

Not every distribution is eligible. Instead, they will need to meet factors like:

  • It’s been at least 5 years since the account owner opened and put funds into their account
  • The account owner is at least 59 and ½ years old at the time of the distribution.
  • The funds taken out are put towards rebuilding or buying a first home for the account owner or qualifying family member (this has a $10,000 lifetime limit)
  • Assets go towards the cost of adopting or having a child
  • The account owner becomes disabled

If none of the conditions above are met, then the distribution will not be eligible to be tax free. That means dealing with income tax and potentially a penalty worth up to 10% of the distribution. However, there are exceptions to this tax rate and penalty fee as well. Some exceptions include if the funds go towards the following:

  • Unreimbursed Medical Expenses: The distribution must be over 7.5% if the person’s AGI (adjusted gross income).
  • Medical Insurance: If the person is unemployed.
  • Eligible Higher Education Costs: This includes fees, tuition, books, supplies, etc.
  • Childbirth or Adoption Expenses: As long as the distribution was made within one year and isn’t more than $5,000.

Can an IRA be Inherited?

Just like an inherited 401(k) it is possible to inherit an IRA. An inherited IRA is also known as a beneficiary IRA. A popular benefit that comes along with an inherited IRA is the fact that any type of IRA can be inherited. This includes the two options we talked about like a Traditional IRA and Roth IRA as well as other types of IRAs like a Simple IRA, and SEP-IRA. Most banks or brokerages can help a person set up their inherited IRA but the easiest option would be to stay with the same company that held the account originally.

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, there are other options to consider. It’s important to note that each type of beneficiary will have their own set of options. For example, designated beneficiaries like a spouse will have different options than another designated beneficiary like a family member or friend. Other factors like life expectancy, age of the account holder, and more play a role.

Frequently Asked Questions

Understanding the rules around an inherited 401(k), inherited IRA, etc., can be confusing. That is why if you have questions, you’re not alone.

What are Inherited 401(k) Distribution Options?

Some inherited 401(k) distributions options include:

  • Roll the funds into your own retirement account
  • Take out a lump sum distribution
  • Take out all funds no more than 5 years after the account holder’s death (if they passed away before 2021)
  • Withdraw all funds no more than 10 years after the account holder’s death (if they passed away after 2021)
  • Take out withdrawals over the course of your lifetime through annual required minimum distributions (RMDs). Life expectancy is a factor of this!

Do You Need to Pay Taxes on 401(k) Distributions?

Potentially! It depends on the type of 401(k) account you have. It’s important to note that you could also pay taxes on an inherited 401(k) as well. The best way to truly understand these retirement accounts is to get in touch with a professional. There are a variety of professionals that may be able to help. If you specifically want to learn more about your 401(k) plan you should start by talking to your employer. However other professionals like a tax advisor, and an investment advisor may also be able to help!

Which is the Best Retirement Account: a 401(k) or IRA?

An online article cannot tell you the best account for your situation. The best option available will depend on a variety of different factors. For example, if your employer doesn’t offer a 401(k) then that means that option doesn’t even exist for you! You will want to make sure to get in touch with a professional.

If you find yourself with an inherited 401(k) or inherited IRA then those accounts can be confusing as well. You will want to also talk to a financial professional regardless of whether it is an inherited 401(k) or inherited IRA in order to get the best information possible!

Why is the Higher Income Tax Bracket Important When it Comes to an Inherited IRA?

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!

Article References

https://www.investopedia.com/terms/1/401kplan.asp

https://www.fool.com/retirement/plans/401k/inherited/

https://www.investopedia.com/terms/t/traditionalira.asp

https://www.investopedia.com/terms/r/rothira.asp

https://www.unionbank.com/personal/financial-insights/investing/family-finance/inherited-ira-rules-beneficiary-options-and-withdrawals

https://www.broadridgeadvisor.com/kt/HtmlNL.aspx

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