What to Know If You’ve Inherited a 401(k)0 USER TIPS ADD YOUR TIP
You might have learned the basics of investing in 401(k) retirement accounts when you opened one at work. But what do you need to know about them when you inherit one?
First, a refresher: A 401(k) plan allows an employee to put a percentage of his or her paycheck into the retirement account, which is invested in mutual funds, stocks, bonds or other investments. The employee usually does not have to pay taxes on the amount contributed until it is withdrawn from the account. Many employers also contribute to their workers’ 401(k)s.
While many people spend the funds in their 401(k) during retirement, they can be passed down to heirs. If this is your situation, what you decide to do may depend on whether you’re inheriting from a spouse or a parent. Spouses automatically inherit the 401(k) unless they signed a waiver giving up this right.
If you’re inheriting from a spouse
You have two options. You can:
- Leave the money in the 401(k). But you can’t let the money sit untouched forever: You must take required minimum distributions every year, starting when the original owner would have reached age 70.5. So if your husband dies at 69.5 and you inherit the account, you must start taking distributions the next year. (If you’re under 59.5 years old and worried about the usual penalty for withdrawing money from a 401(k) early, rest easy: You won’t be penalized for these required distributions.) Regardless of your age or your spouse’s, you will have to pay income taxes on any amount withdrawn.
- Roll the 401(k) over into an inherited IRA or your own IRA. This allows you to name your own beneficiary and take required minimum distributions based on your age, not your late spouse’s. These distributions are taxed as income. One note of caution, however: If you put it into your own IRA, and you are not yet 59.5 years old, you cannot withdraw money from it without paying the early distribution penalty of 10 percent plus regular income taxes.
If you’re inheriting from someone else
If you’re inheriting from a parent or other person besides a spouse, your options may be determined by the rules of the specific 401(k) plan. Some plans require you to take all the money out within about five years, and you will owe regular income taxes on the amount withdrawn each year. The plan may also allow you to:
- Leave the money in the 401(k) and take distributions according to the previous owner’s requirements.
- Roll the account over to an inherited IRA. This allows you to take distributions according to your age, not the previous owner’s. For this reason, it’s also known as a stretch IRA since you can stretch the distributions out for longer if you were younger than the original account holder. However, the money must be transferred directly to the IRA, rather than going to you, then going into the IRA.
Regardless of which you choose, remember that distributions and withdrawals are taxed at your regular income tax rate. And remember to never skip required minimum distributions, or you’ll be hit with a financial penalty.
If you inherit a Roth 401(k)
Inheriting a Roth 401(k) works the same as inheriting a traditional 401(k). The only difference is that, because taxes have already been paid on the amount contributed, you do not have to pay income taxes when that money is withdrawn. That may impact when you start taking distributions from the account, as you don’t have to claim the money as income or worry about inching into a higher tax bracket.
What to do when you inherit any 401(k)
- Contact the firm that runs the 401(k).
- Consult with a financial adviser or lawyer if needed.
- Decide which of the above options to take.