Are Inherited 401(k)s Taxable? Rules for Beneficiaries

Inheriting a 401(k) plan differs from other assets like real estate or bank accounts. These retirement accounts come with specific tax considerations for beneficiaries. Understanding these rules is important, as they significantly affect the amount of money received and tax obligations.

Taxation Basics for Inherited 401(k)s

Distributions from inherited traditional 401(k)s are taxable as ordinary income to the beneficiary. This is because contributions and earnings grew tax-deferred within the account. Unlike other inherited assets, there is no “step-up in basis” for inherited retirement accounts. The tax amount is based on the beneficiary’s ordinary income tax rate.

Inherited Roth 401(k)s have different tax treatment. Qualified distributions from an inherited Roth 401(k) are generally tax-free if the account holder contributed for at least five years before withdrawals began. State income taxes may also apply to inherited 401(k) distributions, depending on the beneficiary’s state of residence.

Beneficiary Categories and Their Rules

The rules and distribution requirements for an inherited 401(k) depend on the beneficiary’s relationship to the deceased account owner. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 introduced changes affecting how most non-spouse beneficiaries must withdraw inherited funds. Understanding these distinctions is important for managing the inherited assets.

Spousal Beneficiaries

Spousal beneficiaries generally have the most flexibility. A surviving spouse can roll over the inherited 401(k) into their own Individual Retirement Account (IRA) or 401(k) plan. This allows funds to continue growing tax-deferred, with required minimum distributions (RMDs) beginning at their own RMD age, typically 73. Alternatively, a spouse can treat the inherited 401(k) as their own, or keep the funds as an inherited 401(k) (sometimes called a Beneficiary IRA), allowing distributions based on their life expectancy. If the deceased spouse was already taking RMDs, the surviving spouse must generally continue those distributions.

Non-Spousal Designated Beneficiaries

Most non-spousal designated beneficiaries are subject to the “10-Year Rule” under the SECURE Act. This rule requires the entire inherited 401(k) account to be distributed by the end of the calendar year containing the 10th anniversary of the original owner’s death. If the original owner died before their RMD beginning date, there are generally no annual RMDs within this 10-year period. However, if the original owner had already started RMDs, the non-spousal beneficiary must continue annual RMDs in years one through nine, with the full balance distributed by the end of the 10th year.

Eligible Designated Beneficiaries (EDBs)

Certain beneficiaries qualify as “Eligible Designated Beneficiaries” (EDBs) and are exempt from the 10-year rule. This category includes the surviving spouse, minor children of the deceased, disabled individuals, chronically ill individuals, or individuals not more than 10 years younger than the deceased. EDBs may stretch distributions over their own life expectancy. For a minor child, this life expectancy period typically applies until they reach the age of majority (usually 21), after which the 10-year rule generally begins.

Non-Designated Beneficiaries (Estates, Trusts, Charities)

When a non-individual entity, such as an estate, trust, or charity, is named as the beneficiary, different rules apply. If the original account owner died before their required beginning date for RMDs, the “5-year rule” generally applies. This rule requires the entire account balance to be distributed by the end of the fifth calendar year following the owner’s death. If death occurred on or after their required beginning date, distributions are based on the deceased owner’s remaining life expectancy. For trusts, specific provisions may allow trust beneficiaries to be treated as designated beneficiaries, affecting the distribution timeline.

Distribution Choices and Tax Implications

Beneficiaries often have choices regarding how they take distributions from an inherited 401(k), and these decisions directly impact their tax burden. While the rules dictate the latest date by which funds must be withdrawn, beneficiaries usually have flexibility within that timeframe to manage their taxable income. Strategic planning around these distributions can help mitigate the overall tax impact.

For beneficiaries subject to the 10-year rule, taking a lump-sum distribution means the entire amount is taxed as ordinary income in the year it is received. This can significantly increase the beneficiary’s taxable income for that year and potentially push them into a higher tax bracket. Spreading distributions out over the 10-year period, instead of taking a lump sum, can help manage annual taxable income and potentially keep the beneficiary in a lower tax bracket. This approach allows for tax planning to align withdrawals with periods of lower income or higher deductions.

Spousal beneficiaries have options that provide greater control over the inherited funds. Rolling over the inherited 401(k) into their own retirement account allows them to delay RMDs until their own RMD age, providing more time for tax-deferred growth. Maintaining the funds as an inherited IRA, on the other hand, might require RMDs to begin sooner, depending on the deceased spouse’s age at death and whether they were already taking distributions. Choosing a rollover provides access to funds without penalty, similar to their own retirement accounts, but taking early withdrawals from their own account before age 59½ could incur a 10% penalty unless an exception applies. The decision between these options should consider the spouse’s age, immediate financial needs, and long-term retirement planning goals.

Tax Reporting for Inherited Funds

When an inherited 401(k) distribution is taken, the financial institution that holds the account will issue Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form is essential for accurately reporting the distribution on a tax return. It details the amount distributed and indicates the nature of the payment.

Key boxes on Form 1099-R include Box 1, which shows the “Gross Distribution,” representing the total amount paid out. Box 2a indicates the “Taxable Amount,” which is the portion of the distribution subject to income tax. Box 7, “Distribution Codes,” provides information about the type of distribution; common codes for inherited accounts include “4” for death, or “G” for a direct rollover.

Beneficiaries must report these distributions on their federal tax Form 1040. The gross distribution from Box 1 of Form 1099-R is typically reported on line 5a, while the taxable amount from Box 2a is reported on line 5b. Accurately reporting the taxable portion helps ensure compliance and proper tax calculation for inherited 401(k) funds.