What You Need to Know

Inheriting a 401(k)

Picturing an inheritance, it can be easy to imagine a lump sum payment, free from complications and of course, taxes. In reality, the typical inheritance tends to be much more complicated. More than just an estate, an inheritance can include multiple investments and financial accounts beneficiaries have little experience in managing. Prominently featured among those are 401(k) plans; employer-sponsored retirement plans often left to spouses or other loved ones as part of an inheritance. If you’ve inherited a 401(k) plan, chances are it’s your first time inheriting one, and chances are you have questions about it. Understanding the options, obligations, and potential pitfalls included can help you take the best advantage of your inheritance. Possibly just as important, inaction can lead to trouble; inherited 401(k) plans can be subject to severe taxes and other financial penalties.

401(k) plans often constitute part of a larger retirement planning strategy. Retirement planning is more aptly described as retirement predicting. Account holders, basing strategies off lifestyle goals and life expectancy, create retirement savings accounts which often include 401(k) plans. When these accounts outlive their account holders, they still continue to exist. In cases where no beneficiary is listed, 401(k) plans are absorbed into the estate. When there is a beneficiary, the 401(k)-retirement savings account (with all its rules, penalties, and tax obligations) will become the beneficiary’s responsibility. For many inheriting a 401(k), this is uncharted territory. Even for those familiar with 401(k) plans, inheriting one can lead to new and unforeseen challenges.

The Details

401(k) Plans

401(k) plans are kind of a big deal. At the end of 2018, Americans had over $5 trillion invested in over half a million 401(k) accounts. That figure represents almost 1/5 of overall retirement savings nationwide, according to a study by the Investment Company Institute (ICI). A 401(k) plan is a retirement savings account sponsored by an employer, with financial obligations and advantages unique to it. The financial burden for employers offering 401(k) plans is typically reduced when compared to the traditional pension system, leading more employers to choose 401(k) plans as employee incentives. ICI estimates over 55 million Americans actively participate in 401(k) plans. Taxes on invested amounts are paid upon withdrawal, and account holders must wait until age 59 1/2 to access funds without incurring an additional penalty. These restrictions can dissuade account holders from accessing the entirety of funds before death, with their remaining 401(k) plan passed along as inheritance.

If there are no beneficiaries listed for a 401(k) plan, the plan becomes part of the overall estate with assets distributed accordingly.

Inheritance Beneficiaries

By default, spouses will inherit 401(k) plans (if not already deceased themselves, of course). Spouses may choose to sign a waiver, refusing to accept responsibility for the account, in which case the 401(k) will go to a different listed beneficiary. If there are no beneficiaries listed for a 401(k) plan, the plan becomes part of the overall estate with assets distributed accordingly. Your relationship with the deceased matters. Spouses can take advantage of opportunities others cannot offering, at least, minimal consolation for their loss.

A spouse inheriting a 401(k) can roll the account into an existing IRA. The option to roll an inherited 401(k) into an IRA is unique to spouses and may offer significant advantages if exercised strategically. Typically, a 401(k) plan requires holders to begin taking withdrawals, known as a Required Minimum Distributions, at age 70 1/2. Also known as RMDs, these withdrawal minimums and their age limits become the responsibility of the beneficiary to maintain.

Spouses rolling a 401(k) into an existing IRA position themselves to avoid Required Minimum Distributions. Keeping a 401(k) intact instead maintains the minimum age for account withdrawal without penalty (59 1/2) and the minimum age for taking RMDs (70 1/2). Based on the original account holder’s age, this means heirs can be subject to the existing withdrawal schedule, even if that means immediately making RMDs. These demands can create a withdrawal and taxation tempo you’re unwilling to accept.

Inherited IRAs

An option open to both spouses and non-spouses alike is to move the 401(k) funds into an inherited IRA. Spouses without an existing IRA, and non-spouses can move a 401(k) inheritance into this type of retirement account. Money withdrawn from an inherited IRA is subject to income tax, which may influence your schedule for accessing it. Money invested in an inherited IRA can be accessed in one of four ways: over your life expectancy, immediately, over five years, or over the oldest life expectancy.

Immediate withdrawal of funds from an inherited IRA can grant access to a large sum of money but may create a headache or two. Funds are taxed upon withdrawal, with the withdrawn amount contributing to annual taxable income. A misstep here and you can find yourself situated in a new tax bracket, with more taxes to boot. Withdrawals spaced over five years simply spread the tax burden and the assets, easing their impacts on the heir. A withdrawal schedule based on predicted life expectancy can offer the most stability.

It’s possible to predict the average RMDs you could expect, based on your own age and the value of your inherited 401(k). Find your age and corresponding life expectancy factor on the IRS Uniform Lifetime Table (here). Divide the 401(k)-plan balance (as of 12/31 last year) by your life expectancy value to see what kind of withdrawals you’ll have to make.

Single Life Expectancy Value / Account Balance as of Dec. 31 = Projected RMD

Inherited 401(k): Other Alternatives

Leaving the inheritance as an existing 401(k) is another form of action, although you’ll want to verify that’s the best decision before going forward.  Perhaps the easiest strategy, there are pitfalls waiting for the unprepared.  Inherit a 401(k) and inherit the original account holder’s RMD schedule, including their penalties for withdrawals made before age 59 1/2.  This option also prevents heirs from passing the account to a listed beneficiary of their own, with assets becoming part of the heir’s estate in case of tragedy. 

A 401(k) unaltered will be subject to any pre-existing conditions the employer may have placed on the plan.  This can include conditions such as immediate payout, or payout over a specific timeline beyond the heir’s control.  While this alternative has the least number of initial obstacles, it may not be the most advantageous.  The next-simplest option, depositing the total amount into another type of savings account, can lead to serious tax headaches and is generally inadvisable. 

Speaking to an Advisor

An inherited 401(k) carries unique advantages and challenges.  Inheritances can be difficult to manage on the best days, and even more so while coping with the loss of a loved one.  To help bring clarity to your inheritance, speak to a financial advisor.  Calculate realistic RMDs based on your own inheritance and learn how those withdrawals will affect you come tax time.  Remember that RMDs are minimums; you may choose to withdraw more depending on your ability to bear the tax burden.  Explore the benefits of IRAs, inherited IRAs, and different withdrawal schedules.  Find the right balance between accessing your inherited assets, their tax obligations, and your personal finances with the help of a professional.  Contact ProsperiFi today and schedule a consultation to learn how you can best approach your inherited 401(k).

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There can be no guarantee that strategies promoted will be successful.

This information is not intended to be suitable for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.