If you have worked hard all your life, you’ll want every cent of all the money you earned to go directly to the beneficiaries, whether it’s your children, a charity that’s close to your heart, or simply a family member or friend.
But, if there’s a tax for the beneficiary to pay on receipt of the inheritance, this could influence how much you want to give each beneficiary in your will.
That’s why it literally pays to read articles like this one, designed to tell you whether or not beneficiaries are required to pay a tax on their 401k inheritance, and if so, how much.
We will also cover all of your most frequently asked questions on the subject along the way.
By the end of the article at the wrap up, you’ll know exactly where you and your beneficiaries stand, and from that point you can start to make decisions about your money.
Please feel free to scroll ahead to any section that jumps out at you. Here goes.
Do Beneficiaries Pay Tax On 401k Inheritance?
In normal circumstances, people who inherit money (or property for that matter) don’t usually have to pay income tax on it. Inheritances are not typically considered income for federal tax purposes. However, this is not always the case…
Any beneficiary that inherits 401k assets is responsible for paying 401k inheritance tax.
What Are A Beneficiary’s Options When They Inherit A 401k?
If you expect to inherit a 401k, it’s important to know what your options are if you want to minimize tax liability.
Ok, so let’s spell out what a beneficiary can do when they inherit a 401k.
- They can withdraw all the money right away and pay whatever income tax is due
- Roll the account over to their own account (whether it’s new or an existing account)
- Roll the money over to an inherited Individual Retirement Account (IRA)
- Leave the money in the plan for up to 5 years (and then either take the funds or roll them over)
- Or, they can decline the money, and let the money go to an alternate beneficiary
How Is a 401(k) Taxed When Inherited? Why Is It Different To Regular Inheritance?
When a person passes, their 401k becomes part of their taxable estate.
The individual who inherits the account is generally expected to keep receiving distributions, and the distributions generally follow the same tax treatment as would apply to the original account holder.
Distributions from a 401(k) are taxed as ordinary income, and as such this means that the beneficiary is responsible for reporting these distributions, and paying the necessary income taxes on it.
So, if there were any taxes due on earnings in the account, these still have to be paid.
However, at this point it’s worth noting that if the beneficiary is a spouse, they are exempt from the 10% early withdrawal penalty, provided that they roll the money over into an inherited Individual Retirement Account (IRA).
There may still be a penalty to pay, however, if the money left in the account remains untouched for a period of 10 years after the original owner’s passing.
Although it’s worth noting that there can be exceptions to this rule, for example in the case of minors, the disabled, and the chronically ill.
How To Avoid Inheritance Tax On An Inherited 401(k)?
Out of the various options available to you, the easiest way to minimize the tax payable on the 401k inheritance tax, at least if you’re a spouse, would be to roll the money over into an inherited IRA.
If you were to press ahead with this method, you need to bear in mind that the standard Required Minimum Distributions (RMDs) apply.
This means that you must start withdrawing the amounts from the account annually, starting with the year that you reach an age of 72.
But, as we mentioned earlier, there are several options before you, and you need to consider whether the method which helps the most with tax avoidance is really the route you want to go for.
For example, if you feel like you don’t need the money (perhaps you’re a spouse who has already retired) then you could simply allow the money to pass on to the next beneficiary.
But if you plan to do this, you must also bear in mind that you will also be passing on the accompanying tax burden.
If, however, you inherit a 401k from a parent, we have slightly different advice to proffer.
You do not have to accept the monthly distributions, and can instead make larger withdrawals if you so wish.
However, if you decide to go down this route, maybe you have something expensive you want to pay for, then you should bear in mind that larger withdrawals can push you into a higher marginal tax bracket.
What’s more, this could also trigger the 3.8% Medicare surtax.
But whatever it is you want to do with the account, you would be well advised to do so within 10 years of the original owner’s passing, so as not to bring about the staggering 50% penalty fee.
As to which option is best for you, if the original owner was your parent, this very much depends on your personal circumstances.
So, as we have discussed, beneficiaries are, unfortunately, required to pay tax on any 401k that they inherit.
But it’s not all bad news because, you would have a number of options laid open to you about what you can do with your account, and some of these options may mean not having to pay income tax in the foreseeable future.
But the issue is whatever option you look at has both pros and cons, and sorting through them can be quite the minefield. So, for this reason, we would argue that you would be well advised to seek out a financial advisor who can help you.
They can look at your current circumstances, report to you your best options, and save you some hassle!