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How to Make the Most of Inherited 401(k) Funds

How to Make the Most of Inherited 401(k) Funds

| May 10, 2024

Unless you’re married or in a long-term living arrangement, you might not know you’re part of someone else's retirement plan. You might be named as a beneficiary — primary or contingent — in a family member or friend’s 401(k) retirement plan. 

If you are a named beneficiary, you might inherit the 401(k) of a loved one who dies, and there is plenty to know about the options and rules you must follow with an inherited 401(k). 

Your options could be affected by several factors, including your relationship to the account owner, the age of the account owner at death, and whether the account owner had begun taking required minimum distributions (RMDs) from the retirement account. 

Here is how to make the most of your inherited 401(k) funds. 

What Is an Inherited 401(k)? 

A 401(k) is a retirement savings account sponsored by an employer. Someone contributes pre-tax dollars to the account. The employer may match some or all of the contributions, and the money grows tax-free, but taxes will be due when the money is withdrawn. If the account is a Roth 401(k), the contributions are after-tax, and no taxes will be required on withdrawals. 

If money is left in an account when an account owner dies, you could inherit the 401(k) if you’re the spouse or non-souse, someone named as a beneficiary. The account passes on to a primary beneficiary, unless the person is dead or can’t be located. Then, the account goes to a contingent beneficiary. 

Rules for an Inherited 401(k) 

What you can do with the account and how it might impact your taxes depends on whether you inherit the 401(k) as a spouse or non-spouse. The rules are different for each situation. 

The rules also differ for inheriting a 401(k) as a minor child, someone who is chronically ill or disabled, or someone who is not more than 10 years younger than the loved one who has passed. 

Options for a Spouse 

If you’re the surviving spouse who inherits the 401(k), you have five options: 

Take a Lump Sum 

You can take a lump sum payout and not incur an early withdrawal penalty. However, the money will be treated as ordinary income, which could lead to a huge tax bill or push you into a higher tax bracket. 

Roll Over the Inherited 401(k) 

You can roll the inherited 401(k) into your 401(k) or traditional individual retirement account (IRA). The typical rules for those accounts would apply and this allows your money to continue to grow. 

Transfer Account to an Inherited IRA 

As a spouse, especially if you have not reached the age of 59½, you can transfer the inherited 401(k) to a new inherited IRA. This would allow you to take distributions from the account without penalties. 

Leave the Inherited 401(k) Where It Is 

If you don’t need the money, this allows you to stretch out withdrawals, minimizing taxes and allowing the remaining money to grow. You also can take RMDs based on your life expectancy, even if your spouse was already taking them at 73. 

Disclaim the Inheritance 

If you don’t need the money, you can disclaim the inheritance. The inherited 401(k) then passes on to the next named contingency beneficiary or follows the plan’s default rule. 

Consider consulting a financial advisor, such as Good Life Morehead City, to help guide you in making a decision that is best for your situation. 

Options for a Non-Spouse 

If you’re a non-spousal beneficiary, you can’t roll the inherited 401(k) into your retirement account. You have four options: take a lump sum, transfer the funds directly into an inherited IRA, leave the money in the 401(k), or disclaim the inheritance. 

Taking the lump sum may have tax implications. The money from a 401(k) would be taxed as ordinary income and could push you into a higher tax bracket. If the account is a Roth 401(k), you won’t have to pay taxes on the withdrawal. 

Transferring to the inherited IRA or leaving the 401(k) in place will be subject to the 10-year rule, which requires the accounts to be depleted within 10 years. 

Seek Help From a Financial Advisor 

If you’ve inherited a 401(k), you might want to talk through your options with a financial advisor. Good Life Morehead City has deep experience with retirement planning and can help. 

Get in touch today to schedule a no-obligation consultation.