Ideally, 401(k) plans are designed so that workers can use the money they save to spend during retirement. Yet often, workers don't end up using all of their 401(k) money before they die, and as a result, the rights to their accounts go to the beneficiaries they've named to inherit the 401(k) assets at their death. When that happens, the heirs face a challenge: how to deal with the inherited 401(k) without running into big tax problems. Below, you'll find out more about the pitfalls that many people run into when they inherit a 401(k) and how to avoid them and make the most of your inheritance.
The basic rules for inheriting a 401(k)
In general, two sets of rules govern 401(k) inheritance: IRS rules and the guidelines of your employer's 401(k) plan. The IRS generally sets the outer boundaries for what's permitted in inheriting a 401(k) without running afoul of the tax laws. However, an employer can generally adopt more restrictive requirements that can limit your options and force you into less attractive alternatives.
Typically, though, you'll have several options in dealing with an inherited IRA. You'll always have the right to take a lump-sum distribution, and some plans will allow you to keep money within the 401(k) account for a period of time up to five years. Surviving spouses typically have the right to roll over a lump-sum distribution into their own rollover IRA, treating it the same as their own retirement assets.
For beneficiaries other than a surviving spouse, rolling over assets into your own IRA isn't allowed. What you often can do, though, is to create an inherited IRA. This retirement account has to remain separate from your own retirement assets, and the distribution rules for the inherited account are different from what governs your own IRAs and 401(k) accounts. Done correctly, though, the inherited IRA option can help you maximize the value of tax deferral from the 401(k) you inherit.
The biggest issue with inherited 401(k)s
In coming up with a strategy for an inherited 401(k), your biggest consideration is managing the tax burden. Because regular 401(k) accounts were funded with pre-tax money, you'll have to include any withdrawals you make -- whether they're voluntary or mandatory -- in your own taxable income. Minimizing the impact on your tax bill is essential to making the most of the inherited 401(k).
Taking a lump sum from the 401(k) and simply depositing it into a regular non-retirement account is usually the most costly mistake you can make. By doing so, all of your inheritance is subject to immediate income tax, and if the account is sizable, that can push you into a higher tax bracket and have a dramatic impact on your tax liability. Ideally, taking steps to spread out withdrawals over as long a time as possible is the best way to control taxes.
In that light, the spousal rollover and the inherited IRA option for non-spouse beneficiaries are often the ideal way to handle inheriting a 401(k) account. Spouses are subject to their own distribution rules, but they tend to offer a lot of flexibility in timing withdrawals. For younger beneficiaries like children and grandchildren, the inherited IRA option can allow you to take withdrawals over the course of your expected life span, which for many will let you extend the tax-deferred life of your inherited assets by decades. Moreover, spreading out withdrawals over a long period of time means taking out smaller payments annually, which will consequently have a smaller impact on your tax bill and avoid the big disruption in your marginal tax rate that a lump sum can cause.
Some things to keep in mind
In addition to these rules, two other IRS provisions are important to remember. First, IRS rules are focused on establishing the minimum you can take out of inherited 401(k)s and IRAs, with the idea that eventually, you should have to use up tax-advantaged money. As a result, you can almost always choose to take money out of your inherited account faster than the rules provide. By doing so, you'll accelerate the tax hit, but it can still provide financial flexibility that can be valuable in your own personal situation.
The other thing is that distributions from inherited 401(k)s aren't subject to the same 10% penalty that applies to most retirement account withdrawals made before you reach age 59 1/2. Younger beneficiaries can therefore make decisions secure in the knowledge that they won't incur penalties by taking money before retirement age.
Inheriting a 401(k) involves making key financial decisions at a difficult time. By knowing the rules and following them, though, you can make the most of your inheritance and honor the memory of the loved one who left it for you.
Dan Caplinger has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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