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Blog Articles: How Are Inherited 401(k)s Taxed?

How Are Inherited 401(k)s Taxed?
If you anticipate inheriting a 401(k) from a parent, a spouse or someone else, it’s important to know your options for minimizing tax liability.

There are many complicated rules for inheriting assets in the form of retirement plans, workplace plans and Individual Retirement Accounts (IRAs), says a recent article titled “How Much 401(k) Inheritance Taxes Will Really Cost You” from The Madison Leader-Gazette. Any assets passed from one person to another in the form of a 401(k) are taxable. You’ll want to be prepared, states Beck & Lenox Estate Planning and Elder Law, LLC. So, how are inherited 401(k)s taxed?

The inheritance rule for 401(k) tax usually follows the same path as the rules used when making contributions or withdrawals to tax deferred retirement plans. When a person dies, their 401(k) becomes part of their taxable estate.

This means that any taxes due on earnings not paid during the person’s lifetime need to be paid.

Traditional 401(k) plans are funded with pre-tax dollars. This is great for the saver, who gets to defer paying taxes while they are working. When they retire, withdrawals are taxed at their ordinary income tax rate, which is typically lower than when they are working.

There is an exception with Roth 401(k)s, where contributions are made with after-tax dollars and qualified withdrawals are tax free.

How the IRS taxes an inherited 401(k) depends on three factors:

  • The relationship between the account owner and the heir
  • The age of the heir
  • How old the account owner was at the time of death.

Who Pays Taxes on an inherited 401(k)?

The beneficiary who inherits the 401(k) is responsible for paying the tax. They are taxed at the heir’s ordinary income tax rate. This could push the heir into a higher tax bracket. If the beneficiary is not the spouse of the IRA’s original account owner, under the Secure Act, you’re required to withdraw and pay taxes on all assets from the inherited 401(k) within 10 years of the original account owner’s death. Any money left in the account once the 10-year period ends would be subject to a 50% tax penalty. Exceptions to this rule are allowed for minors and beneficiaries who are disabled or chronically ill.

What Should I Do with an Inherited 401(k)?

If your spouse was the original owner, you may leave the money in the plan and take regular distributions, paying income tax on the withdrawals. You may also roll it over into your own 401(k) or to an IRA. This allows the money to continue to grow tax free, until withdrawals are taken.

Can I Avoid Taxes on an Inherited 401(k)?

The only way to avoid taxes on inherited 401(k) would be to disclaim the inheritance, at which point the 401(k) would be passed to the contingent beneficiary. If you don’t need the money, don’t want the tax headaches, or would rather see it go to another family member, this is an option. Most people pay the taxes.

Planning For Taxes When Creating an Estate Plan

Like Beck & Lenox, your estate planning attorney can discuss your taxable assets and how to manage the tax liabilities to your heirs. There are numerous tools to address these and related issues. your heirs will be grateful for your foresight and care.

Reference: The Madison Leader Gazette (July 29, 2022) “How Much 401(k) Inheritance Taxes Will Really Cost You”

 

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