A distant relative, who never married and had no direct heirs, has died and left the entire $400,000 in her 401(k) retirement account to you. Is this a windfall to be spent or invested with no strings attached — not even taxes to pay? Or are there rules for when someone inherits 401(k) retirement funds?
You bet there are.
Much depends on your relationship to the person who died — whether you’re the person’s spouse or not — and how old both you and the 401(k)’s original owner were at the time of that person’s death. Because each 401(k) plan may have its own internal rules as well, and complicated tax issues are involved, it’s wise to consult a tax professional if you ever find yourself in this situation.
But, let’s go ahead and consider some possible common scenarios.
You are the spouse
Under federal law, the surviving spouse gets the 401(k) unless the account holder designates someone else and the spouse has literally signed off on that. If the decedent was single, the money goes to whomever is named as the beneficiary of the 401(k) — even if it’s an ex-spouse who subsequently gave up a claim to the money in a divorce proceedings, The Wall Street Journal says.
As a surviving spouse, you have options similar to those of a non-spousal recipient (see below) but you also have the choice of doing a ”spousal rollover,” moving the money into your own IRA. That can be done without paying income taxes or a penalty. Just make sure the 401(k) plan administrator transfers the inherited money directly to your IRA custodian, rather than sending you a check.
The drawback of the spousal rollover is that once the money is in your account, you’ll pay a 10 percent penalty if you withdraw it before age 59½.
You are not the spouse
Whether you are the child, the third cousin or merely an acquaintance of the person who died, you face these possibilities, among others:
- You may cash out the balance of the 401(k) no later than the end of the fifth year after the person died, which will generate a potentially substantial income tax bill. (Some plans require you to cash out sooner.) However, there will be no early-withdrawal penalty if you’re younger than 59½.
- If the person who died had reached the mandatory withdrawal age of 70½, you can leave the money in the 401(k) plan and withdraw on the same schedule as the decedent. The minimum amount you can withdraw is based on the IRS life expectancy charts for your age if you are younger than the person who died.
- In the year following the year the person died, you can roll the inherited 401(k) money over into an “inherited IRA” and begin taking annual distributions that are at least the amount prescribed by the IRS life expectancy tables. You must take withdrawals no matter how young you are, but you won’t pay the early withdrawal penalty if you’re younger than 59½. This option, which became available in 2007, will stretch your tax liability possibly over several decades. Make sure the 401(k) plan administrator transfers the inherited money directly to your new inherited IRA, instead of sending you a check.
Again, the requirements of the particular 401(k) might be different from those described above, so make sure you review the material carefully and consult a professional.
Does it seem strange that those who inherit a 401(k) have to pay taxes on that money when other types of inheritance are often tax-free? Remember that money in a traditional 401(k) — we’re not discussing Roth 401(k)’s here — was deposited in the account before it was taxed and that the original owner would have paid taxes on any withdrawals.
Have you ever inherited a 401(k)? What complications did you encounter? Please share on our Facebook page.
Karen Datko contributed to this report.