Inherited 401(k): Your options & tax implications

If you are a beneficiary of a loved one's 401(k), there are certain rules and tax implications you should know that can vary based on your relationship to the deceased, your age and other factors.

Here's an overview of your available options and the potential tax consequences of each.

When a 401(k) account holder dies, the balance in their account goes to the designated beneficiary—usually someone the account owner identified when they set up the account.

The relationship of the beneficiary influences the options available for inherited funds. Potential beneficiaries can include:

• Your spouse. 
• Your children and other relatives or friends.
• A trust, charity or other legal entity.

Naming a trust as the beneficiary of a 401(k) can be ideal for account holders with minors, dependents with special needs, or a desire for additional control over their assets. While this approach can offer significant advantages in terms of estate planning, it has unique tax implications.

First, the trust must receive distributions from the 401(k) plan (typically over 10 years) just as an individual beneficiary would. The terms of the trust then govern how those distributions are paid out to the trust beneficiaries.

However, there are some exceptions:

• Non-individual trust beneficiaries. It's common to see trusts that include a charity, church or other organization as a beneficiary. However, if the trust names a non-individual as a beneficiary, IRS rules may require the 401(k) plan to fully distribute funds within five years of the account owner's death. 
• Eligible designated beneficiary. Eligible designated beneficiaries can stretch payments over their lifetimes. In addition to surviving spouses, this category includes minor children of the 401(k) participant,¹ disabled beneficiaries, chronically ill individuals and beneficiaries who are less than 10 years younger than the deceased. 

Considering the complexity of trusts and the potential tax impact of these options, trustees and other interested parties should seek advice from a financial advisor to ensure the management of the inherited 401(k) aligns with the trust's objectives and the beneficiaries' needs.

Inheriting a Roth 401(k) involves different considerations from those associated with a traditional 401(k) due to fundamental differences in tax treatment for each type of account.

With a traditional 401(k), contributions are made pre-tax and reduce taxable income in the year they are made. Taxes on contributions and earnings are deferred until withdrawal, at which point they are taxed as ordinary income.

Contributions to a Roth 401(k) are made with after-tax dollars, meaning there's no tax deduction at the time of contribution. Contributions and earnings grow tax-free, and withdrawals are tax-free in retirement provided certain conditions are met. Beneficiaries can avoid taxes on a Roth 401(k) inheritance as long as the account holder began making contributions to the account at least five years before the beneficiary started taking withdrawals.

For the 2024 tax year and beyond, RMDs aren't required from designated Roth accounts.

Deciding how to manage an inherited 401(k) involves weighing several factors, from your immediate financial needs to your long-term retirement strategy. These are key aspects to keep in mind:

• Financial goals and timeline. Are you seeking asset growth over many years, or do you need immediate income? This will influence whether you roll funds into an inherited IRA for continued growth or take a lump-sum distribution. 
• Current age and RMDs. Younger beneficiaries might benefit from rolling over to an inherited IRA to maximize tax-deferred growth over a longer horizon when this strategy is available to them. Older beneficiaries might need to start taking RMDs immediately to meet their financial needs. 
• Potential growth and tax implications. Leaving the funds in an inherited account or rolling them into an inherited IRA could allow for continued growth with deferred taxes. In contrast, a lump-sum distribution could result in a significant tax burden in the current year. 

Inheriting a 401(k) involves a complex set of choices with significant tax and financial implications. As you navigate your decision, remember the importance of aligning your options with your long-term financial goals.

Connect with a financial advisor for tailored advice to help you determine the most beneficial and tax-efficient strategy, make the most of your inheritance, and honor your loved one's legacy.