Inherited 457(b) Rules: Taxes, Distributions, and Key Guidelines

Receiving an inherited 457(b) plan comes with financial responsibilities that affect taxes, withdrawals, and long-term planning. These employer-sponsored retirement plans, commonly used by state and local government employees, have different rules for beneficiaries compared to IRAs or 401(k)s. Understanding distribution requirements and tax implications is essential to avoid penalties and make informed decisions.

Eligible Beneficiaries

Who inherits a 457(b) plan depends on the original account holder’s beneficiary designation. Spouses, children, other family members, trusts, and charities can be named, but each faces different rules. Spouses generally have the most flexibility, often being allowed to roll the account into their own retirement plan or keep it as an inherited account with required distributions. Non-spouse beneficiaries, such as children or other individuals, must follow stricter withdrawal rules.

Trusts are sometimes named as beneficiaries to control asset distribution, particularly when minor children or individuals with special needs are involved. However, trusts are taxed at higher rates if distributions are retained rather than passed to beneficiaries. Charities, in contrast, can receive the full balance tax-free, making them a strategic option for those looking to maximize charitable giving while minimizing tax burdens on heirs.

Distribution Schedules

The SECURE Act changed how non-spouse beneficiaries withdraw funds from inherited 457(b) plans. Most now have ten years to withdraw the entire balance, eliminating the option to stretch distributions over a lifetime. Withdrawals can be taken in any amount and at any time within this period, but the full balance must be distributed by the deadline.

Certain beneficiaries, known as “eligible designated beneficiaries,” can take distributions over their life expectancy instead of following the ten-year rule. This group includes surviving spouses, minor children (until they reach adulthood), disabled or chronically ill individuals, and beneficiaries less than ten years younger than the original account holder. Once minor children reach adulthood, they must withdraw the remaining balance within ten years.

Employer-specific rules may impose additional restrictions. Some plans require a lump sum payout or have stricter withdrawal schedules than federal regulations. Reviewing the plan document is necessary to understand any additional requirements.

Tax Obligations

Withdrawals from an inherited 457(b) plan are subject to federal income tax, as these accounts are funded with pre-tax contributions. The amount withdrawn is added to the beneficiary’s taxable income for the year, potentially pushing them into a higher tax bracket. Unlike IRAs or 401(k)s, 457(b) plans do not impose an early withdrawal penalty, regardless of the recipient’s age.

State tax treatment varies. Some states fully tax distributions, while others offer exemptions or reduced rates for public-sector retirement income. Beneficiaries should check their state’s tax rules to determine if any special provisions apply.

Tax planning can help manage the impact of distributions. Spreading withdrawals over multiple years may prevent income from spiking into higher tax brackets. Taking distributions in lower-income years, such as after retirement or during a career transition, can also reduce tax liability. Donating a portion of a distribution to a qualified charity may provide a tax deduction, further offsetting taxable income.

Missed Distribution Consequences

Failing to take required withdrawals results in financial penalties. The IRS imposes a 25% excise tax on missed required minimum distributions (RMDs), reduced from 50% under the SECURE 2.0 Act. If corrected within two years, the penalty drops to 10%. This penalty is in addition to regular income taxes, making noncompliance costly.

IRS Form 5329 must be filed to report missed distributions. Beneficiaries can request a waiver if the failure was due to reasonable error and steps are taken to correct it. The IRS may grant relief for reasons such as illness, reliance on incorrect advice, or administrative errors, but ignorance of the requirement is unlikely to be accepted.

Rollover or Transfer Options

Spouses can roll an inherited 457(b) into their own retirement account, such as an IRA or another 457(b) if the plan allows. This defers taxes and lets them take distributions based on their own retirement timeline. A direct rollover prevents an immediate taxable event. If a spouse keeps the account as an inherited 457(b), they must follow beneficiary distribution rules rather than those for account owners.

Non-spouse beneficiaries cannot roll the inherited account into their own retirement plan but may transfer it into an inherited IRA through a trustee-to-trustee transfer. This avoids immediate taxation but does not extend the ten-year withdrawal deadline. Taking a lump sum instead of transferring the funds results in full taxation of the balance in the year of withdrawal, which can create a significant tax burden.