Do You Pay Taxes on an Inherited 401(k)?

An inherited 401(k) account is a financial asset passed down after the original owner’s death. While these plans offer tax advantages during accumulation, their tax treatment changes upon inheritance. Understanding the specific rules for an inherited 401(k) is important, as tax implications vary significantly depending on several factors. Navigating these rules helps beneficiaries manage funds and avoid unexpected tax liabilities.

Understanding Inherited 401(k) Basics

A 401(k) is an employer-sponsored retirement savings plan. There are two primary types: Traditional 401(k)s and Roth 401(k)s, and their tax treatments influence how inherited versions are taxed. Traditional 401(k) contributions are pre-tax, reducing current taxable income. The money grows tax-deferred, and distributions are taxed as ordinary income.

Conversely, Roth 401(k) contributions are after-tax, meaning there is no immediate tax deduction. Qualified distributions from a Roth 401(k) in retirement are entirely tax-free. When a 401(k) is inherited, the tax rules applied to the beneficiary depend largely on whether it was a Traditional or Roth account, and on the relationship of the beneficiary to the original account holder. The age of the original account holder at the time of death can also influence distribution requirements, particularly if they had already begun taking Required Minimum Distributions (RMDs).

Tax Rules for Spousal Beneficiaries

Surviving spouses who inherit a 401(k) generally have the most flexible options regarding the inherited funds. One common choice is to roll over the inherited 401(k) into their own Individual Retirement Account (IRA) or even their own 401(k), effectively treating it as their personal retirement savings. This allows the funds to continue growing tax-deferred if it was a Traditional 401(k), or tax-free if it was a Roth 401(k), until the spouse reaches their own required beginning date for RMDs, which is generally age 73. This strategy provides continued tax-advantaged growth and defers taxation until the spouse’s own retirement.

Alternatively, a surviving spouse can choose to treat the inherited 401(k) as their own account within the existing plan, provided the plan allows for this. A spouse can also remain as a beneficiary of the deceased’s 401(k) and take distributions under beneficiary rules, which often provide more favorable terms than those for non-spousal beneficiaries. Distributions taken under this option are typically taxed as ordinary income for Traditional accounts but are exempt from the 10% early withdrawal penalty regardless of the spouse’s age.

Tax Rules for Non-Spousal Beneficiaries

For non-spousal beneficiaries, such as children, siblings, or friends, the rules for inherited 401(k)s changed significantly with the SECURE Act, which became effective for deaths occurring after December 31, 2019. Most non-spousal beneficiaries are now subject to the “10-year rule,” which mandates that the entire inherited 401(k) account must be fully distributed by the end of the tenth calendar year following the year of the original account holder’s death.

Distributions from an inherited Traditional 401(k) are taxed as ordinary income in the year they are received. If the original account holder had not started RMDs, there is flexibility on when distributions are taken within that timeframe. However, if the original account holder was already taking RMDs at the time of death, the beneficiary must continue to take RMDs annually during the 10-year period. Inherited Roth 401(k) distributions are generally tax-free, provided the account met the five-year rule for qualified distributions.

Exceptions to the 10-Year Rule

There are specific exceptions to the 10-year rule for certain “eligible designated beneficiaries.” These include:
Minor children of the deceased (until they reach age 21, at which point the 10-year rule begins)
Individuals who are disabled or chronically ill
Individuals who are not more than 10 years younger than the deceased account holder

These beneficiaries may be able to stretch distributions over their own life expectancy, offering a longer tax deferral period than the standard 10-year rule.

Required Actions and Tax Reporting

Upon inheriting a 401(k), a beneficiary’s first step is to contact the deceased’s 401(k) plan administrator or employer to initiate the beneficiary claim process. This typically requires providing documentation such as the death certificate and the beneficiary designation forms. The plan administrator will provide information about the available distribution options, which vary based on the beneficiary’s relationship to the deceased and the plan’s specific rules.

The beneficiary must then choose a distribution method, which carries significant tax consequences. Options can include taking a lump-sum distribution, setting up an inherited IRA (for non-spouses), or, for spouses, rolling the funds into their own retirement account. Distributions received from an inherited 401(k) are reported to the Internal Revenue Service (IRS) on Form 1099-R, which the plan administrator will issue. For inherited accounts, Box 7 of Form 1099-R typically contains Code 4, indicating a death benefit, which means the distribution is exempt from the 10% early withdrawal penalty. This income (for Traditional 401(k)s) must then be reported on the beneficiary’s personal income tax return, Form 1040, as ordinary income. Given the complexities involved, consulting with a financial advisor or tax professional is advisable to navigate these choices and ensure compliance with tax regulations.