Inherited 401(k)

Inheriting a 401(k) account following the death of its original account owner can be a bit daunting for many people, especially if the new account holder has never actually dealt with an inherited 401(k) before.

Any person who is faced with this type of situation must first know what they can do and what restrictions are involved with this particular investment vehicle. There are several things to keep in mind when handling such accounts.

How Is a 401(k) Inherited?

A 401(k) can be inherited in the event of the death of the original owner. The plan will typically assign the new account holder is responsible for investing and distributing the funds that are derived from this particular investment vehicle.

The IRS has set up guidelines on how much money one can withdraw from their 401(k) plan.

It is vital that people consider their ages, delayed retirement benefits, employment status, etc. when making decisions about what to do with their inherited 401(k)s.

The rules and regulations regarding the handling of a 401(k) account will depend on how it is inherited.

Typically, a 401(k) account may be inherited by:

  • the account owner’s spouse if they are married
  • someone else duly assigned by the account owner especially if they are single
  • someone else duly assigned by the married account owner aside from the spouse as long as it is supported by a waiver that allows them to name another plan beneficiary

Below are the three factors by which inherited 401(k) accounts will be taxed:

  • relationship to the account owner of the 401(k) plan
  • age when the 401(k) was inherited
  • age of account owner at the time of death

Inheriting a 401(k) as a Spouse

Here are some of the things a spousal beneficiary under the age of 59 1/2 years old can do when he or she inherits a 401(k) account:

Open an Inherited IRA Account

An inherited IRA account is the most convenient way to deal with an inherited 401(k) account. This allows the beneficiary greater flexibility regarding their investments, and they can withdraw funds from this IRA account anytime without having to worry about penalties like those that are imposed on early withdrawals of traditional IRAs.

However, the spouse must fully understand that any money they withdraw from an inherited IRA will be included in their income for that tax year.

So it is advisable that they speak to a tax consultant first before withdrawing funds from their new IRA or making other important decisions about their inheritance.

Rollover the Funds to an Existing IRA Account

A spousal beneficiary may choose to roll over the inherited IRA to his or her existing IRA account.

If he or she executes the rollover prior to reaching the age of 59 1/2 years old, any withdrawal will be treated as a regular distribution. This means that it will come with an income tax plus a 10% early withdrawal penalty.

The rollover should ideally be done when the spousal beneficiary reaches the age of 59 1/2 years old or older so that the early withdrawal penalty may be avoided.

If the original account owner has been taking RMDs before they passed away, the spousal beneficiary has the option to continue with the RMDs or delay the RMDs until they reach 70 1/2 years old.

However, if the spousal beneficiary is already 70 1/2 years old or older, the RMDs will be mandatory.

Take Advantage of Required Minimum Distributions

This option will still make the beneficiary liable for income tax for any distributions taken from the account, although the 10% early withdrawal penalty will no longer be triggered.

RMDs will be available immediately if the spouse died at the age of 70 1/2 or older. But if they died younger than that age, RMDs will only be available once the spousal beneficiary reaches 70 1/2 years old.

Inheriting a 401(k) as a Non-spouse

If the account owner who passed away was not married or was married but opted to name another beneficiary aside from the spouse, there are slightly different options to consider when it comes to deciding what to do with their 401(k) inheritance.

Starting 2020, full payouts have to be done from the inherited 401(k) accounts within 10 years from the death of the original account owner per the SECURE Act.

Non-spouse beneficiaries who are classified as eligible designated beneficiaries such as minors, or chronologically ill, or disabled beneficiaries have the option to stretch out the RMDs for their lifetime.

In a case where the original account owner of the 401(k) plan has not yet reached the age of 70 1/2 years old, distributions can be stretched over the lifetime of the beneficiary or over a five-year period. The latter option would mean that all funds have to be exhausted at the end of the fifth year. The counting of the five-year period begins at the death of the original account owner.

Depending on the plan, a non-spouse beneficiary also has the option to transfer the funds into an inherited IRA account. RMDs will be based on the life expectancy of the beneficiary if the owner has not started taking RMDs. If they already did, RMDs will have to be mandatory for the beneficiary.

Final Thoughts

Inheriting a 401(k) account can mean different things for different people.

For the spouse, they will have to decide between taking all of the funds in a lump sum and paying taxes on it, taking required minimum distributions (RMDs), or rolling the funds over into their existing IRA account.

For non-spouse beneficiaries, whether beneficiary by designation or not, RMDs must be considered when deciding what to do with the inherited 401(k) account money.

There are several factors to take into consideration like age, the health status of beneficiaries, exact terms of plan documents when it comes to rollover options versus distribution options that will determine how significantly one’s options may vary from another’s.

The best thing to do when in doubt is to consult a financial advisor.

Eligible designated beneficiaries include: Spouse of the deceased 401(k) owner Minor child of the deceased 401k owner Chronically ill or disabled beneficiaries
Consulting a financial advisor may help you come up with an informed decision based on your own personal situation. A fiduciary will not be biased when coming up with advice for their clients, unlike brokers who are subject to selling products and services with commissions in mind rather than their clients' best interest.
Theoretically, you can stretch your RMDs over your own lifetime if you are an eligible designated beneficiary. Otherwise, there is a five-year period that starts from the date of passing of the original plan holder/IRA account owner that will apply to all assets held in inherited accounts until exhausted.
As a way to prevent the accumulation of unnecessary funds in traditional IRA accounts and 401(k) plans, required minimum distributions are meant to limit the amount of time these assets can be left untouched for retirement savings.
While the answer to this question doesn't have a straight yes or no response, it all depends on an investor's personal situation. If you are one who intends to retire early because you don't intend to work during your golden years, then investing in a 401(k) may not be for you. The flexibility of being able to take out funds whenever needed makes these plans ideal for those who do not view retirement as an option unless they are financially stable enough to fully quit their job at any given time.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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