How to Minimize Taxes on an Inherited 401(k)

Your retirement account is designed to provide income to you throughout your retirement years. But in the event that you pass away prematurely, what will become of your money? Your spouse or another beneficiary will inherit it, but did you know that they could owe considerable taxes on that inheritance? Proper planning ahead of time can help relieve this burden.

If your spouse inherits the account… Spouses who inherit a 401(k) account, but who are under age 59.5, can take the following actions:

• Withdraw the money as a lump sum, and pay taxes on the income
• Leave the money in the account, and begin withdrawals at some point after age 59.5
• Roll the account in their own 401(k), or into an IRA
• Roll the account into a new Inherited IRA, which can allow them to take early withdrawals without the 10 percent penalty

Additionally, the deceased spouse’s age at time of death will determine whether required minimum distributions will be necessary. RMDs begin at age 72.

If a non-spouse inherits the account… The rules become a bit more tricky. Under the SECURE Act, this person will be required to withdraw all funds in the account within ten years. And of course, taxes will be due on those withdrawals. If any funds are left in the account beyond the ten-year deadline, that money will be taxed at a rate of 50 percent. Non-spouse beneficiaries can also choose to roll the funds into an inherited IRA.

Because taxes can significantly impact beneficiaries of a 401(k), it is important to understand the rules when choosing beneficiaries and drafting your estate plan. Let’s discuss those rules at our next appointment, so that you and your family members can be familiar with potential consequences in the future.

As always, we encourage you to consult with a tax professional regarding any specific tax questions or needs.