Americans rely on 401(k) plans for their retirement savings to a huge extent, putting trillions of dollars into these workplace-provided retirement accounts to save for their golden years. Yet often, retirement savers end up outliving their 401(k) accounts, and that means the leftover money goes to someone else.
If you're fortunate enough to inherit a 401(k) account, it's a huge opportunity to help you shore up your own financial situation. However, many people make costly mistakes when it comes to a 401(k) inheritance. To help put you at ease and avoid potential pitfalls, we'll walk you through everything you need to know about properly handling a 401(k) account that's been left to you by a loved one.
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What is a 401(k)?
A 401(k) is a tax-favored investing account that many employers provide for their employees to help them save for retirement. Unlike IRAs, most 401(k)s have limited menus of investment choices from which you can pick, preventing you from having full discretion to decide how to invest your retirement savings. However, most 401(k) plans offer mutual funds that cover a wide range of different types of investments, including funds that own stocks, bonds, and other asset classes.
There's more than $5 trillion invested in 401(k) plans, according to the Investment Company Institute, and that represents almost 20% of the total that Americans have saved for retirement. According to the latest available figures, more than 550,000 employers have established 401(k) plans, and roughly 55 million workers participate in plans their employers offer.
The purpose of a 401(k) account is to provide for a person's retirement, so in a perfect world, workers would use the 401(k) during their careers to accumulate assets, and then take withdrawals in retirement to spend them all down. Yet, as you'll see in more detail below, many people don't spend all of their 401(k) money before they die. That's the reason 401(k) plans require their participants to name beneficiaries for their accounts, and after death, the worker's remaining balance will go to the person the worker named to receive it.
If you inherit a 401(k), you'll have to deal with plenty of rules, and knowing them fully will help you make the most of the opportunity. First, let's look more closely at the process of inheriting a 401(k) account.
What happens when you inherit a 401(k)?
The process of inheriting a 401(k) usually starts decades before any inheritance takes place. When you first sign up for a 401(k) plan at work, you'll be asked to choose your 401(k) beneficiaries, who will receive any remaining 401(k) assets at your death. In some cases, 401(k) accountholders choose to name a primary beneficiary as well as contingent beneficiaries. The primary beneficiary receives all of the assets in the 401(k) if that beneficiary is alive at the accountholder's death. However, if the primary beneficiary has died first or chooses not to accept the remaining 401(k) funds, then contingent beneficiaries are next in line to get all or part of the assets left in the 401(k) account.
You can generally name anyone you'd like to be a 401(k) beneficiary, but it's most common to name family members. If you're married, naming your spouse is a natural thing to do, and federal law recognizes the spousal relationship by requiring married 401(k) participants to get spousal approval to name a different primary beneficiary. But you'll also often find that children, parents, siblings, and other relatives appear as primary or contingent beneficiaries.
One critical fact to remember is that 401(k) beneficiary designation forms are the sole documents directing who inherits any remaining funds in the account. Even if you have a will that says someone else should receive your property, 401(k) money will still go to the beneficiary you named on the designation form.
What rules apply to 401(k) inheritances?
To determine which rules cover a 401(k) inheritance, you have to know three things:
- How the beneficiary is related to the accountholder.
- How old the original 401(k) accountholder was at death.
- What the 401(k) plan document specifically allows.
If you're the spouse of the accountholder, and you're the beneficiary, then you'll have some options available that others can't use. In addition, there are some different distribution options available, depending on whether the accountholder was old enough to start taking required minimum distributions. The RMD requirement almost always kicks in when a person reaches age 70 1/2, so you'll need to know the age of the person who left the 401(k) to you in order to navigate the rules correctly.
Inherited 401(k) distribution options
- Heirs can take an immediate lump-sum distribution of the entire 401(k) account balance.
- If the original owner wasn't yet required to take distributions from the 401(k) -- typically because they hadn't yet turned 70 1/2 -- then heirs can keep money in the account for up to five years after the owner's death.
- If the plan allows, then they can take minimum annual withdrawals from the 401(k) over the course of their lifetime, as determined by their life expectancy according to special IRS tables.
- They can arrange for a trustee-to-trustee transfer to an inherited IRA account.
- For spouse beneficiaries only, they can roll over the original owner's 401(k) into an IRA in their own name. Thereafter, the IRA will be treated as if the spouse beneficiary had always owned it, with the same rules governing withdrawals and other aspects of managing the retirement account as any other IRA the spouse beneficiary has.
Below, we'll talk about the advantages and disadvantages of each of these options.
The easiest way to for a spouse to inherit a 401(k)
By far the simplest thing a spouse beneficiary can do with an inherited 401(k) is roll it over into an IRA in the spouse's own name. That allows the inherited retirement assets to be combined with the rest of the surviving spouse's retirement savings, facilitating efficient management and investment and allowing for greater coordination of financial planning. Coordinating all of your retirement assets into a single account can also save on fees and other costs. Typically, the surviving spouse will arrange to have the deceased spouse's employer transfer the 401(k) assets directly to the financial institution that the surviving spouse chooses to hold the IRA.
Amid all of those benefits, the negative of rolling over an inherited 401(k) is that a surviving spouse can lose the ability to take penalty-free withdrawals from the 401(k). In particular, if the surviving spouse hasn't yet turned 59 1/2, then money in the surviving spouse's own IRA will be subject to a 10% penalty on early IRA withdrawals. Many other options available to any 401(k) beneficiary can avoid that penalty. So, if you expect to have cash needs that you'll need to withdraw from a 401(k) to satisfy, then a rollover might not be the best move.
Lump-sum withdrawals and 401(k) inheritances
The IRS rules let any beneficiary withdraw the entire balance of an inherited 401(k) in a lump sum. That's easy to do and requires the least work, but it comes with big drawbacks.
The main problem is that if you take your entire 401(k) balance out at once, you'll typically have a big tax bill. That's because most 401(k) withdrawals are taxable to the recipient in the year in which you take the withdrawal. If the 401(k) inheritance was sizable, then the taxes can put you into an entirely new tax bracket. That in turn will cost you more in taxes than you're used to seeing.
The other methods of taking 401(k) inheritances don't avoid that taxation forever. However, by letting you take money out more slowly, you're able to control the amount of tax you have to pay each year. Over time, taking withdrawals in measured chunks rather than all at once will typically save you more in total taxes paid.
Using the five-year rule to buy some time
Because taking a lump sum can be so costly in terms of taxes, considering alternatives is always a smart choice. In addition to the lump-sum option, 401(k) plans offer beneficiaries the opportunity to take withdrawals over a five-year period. As long as they take out the full amount of the 401(k)'s assets, the timing of exactly when they take those withdrawals is completely up to them.
This option will always be available to you as long as the person from whom you're inheriting the 401(k) was younger than 70 1/2 years old and therefore didn't yet have to start taking required minimum distributions. Those who inherit from someone who had already started taking RMDs will usually have to choose one of the other methods available to heirs, with the added requirement that they'll typically have to take out at least as much as the deceased person would have been required to withdraw each year.
Although the five-year rule lets you have almost unlimited discretion about when to take money out over the ensuing five years, it's still not a huge length of time over which to spread out the potential tax liability. As you'll see below, there are other choices that can often give you a lot longer to preserve the tax benefits of the retirement account and reduce the amount of tax you have to pay in any given year.
Using a "stretch" 401(k)
For non-spouse beneficiaries who want to take maximum advantage of an inherited 401(k), the smartest choice is to take distributions from their inherited 401(k) over the course of their entire lifetimes, as defined by IRS life expectancy tables. This lets you stretch out distributions from the account to the maximum permitted extent, and that's where the "stretch 401(k)" strategy gets its name.
The primary benefit of using a stretch 401(k) is that you can get years or even decades of extra tax benefits by letting the account continue to grow over time. Beneficiaries also get to take relatively small withdrawals year after year, reducing the amount of taxable income they have to recognize on their annual tax returns.
Just because you use a stretch 401(k) option doesn't keep you from taking out bigger withdrawals if you need them. The stretch 401(k) rules only define the absolute minimum you're required to take as withdrawals. There's no corresponding maximum, meaning you can withdraw more than the minimum whenever you'd like.
What to do if your inherited 401(k) doesn't allow the stretch option
There's one big catch with stretch 401(k)s: Employers aren't required to allow them. The IRS decided that requiring employers to commit to handling stretch 401(k)s for decades after the deaths of their employees was a potentially unfair burden, so employers can choose not to include stretch 401(k) provisions in their retirement plans.
However, if the inherited 401(k) plan doesn't allow you to use a stretch 401(k) option, you can always ask the employer holding the 401(k) assets to do a trustee-to-trustee transfer of those assets to an inherited IRA account. The rules covering inherited IRAs do allow stretch IRAs, and once the old inherited 401(k) money is in an inherited IRA, the more favorable IRA rules will apply.
How much do I have to take out of my inherited 401(k) account?
For those whose plans let them do stretch 401(k)s, the key to using them correctly is making sure you take out the right required minimum distribution every year. The IRS will insist that you take withdrawals in order to limit the amount of time you're able to take advantage of the tax benefits of an inherited 401(k). By using life expectancy tables provided by the IRS, you'll be forced to take a certain amount of withdrawals each year, with the end goal of depleting the account completely.
To calculate the RMD for each year, do the following three things:
- Come up with the value of your inherited 401(k) as of Dec. 31 of the previous year.
- Go to the IRS table and find the correct distribution factor to use.
- Divide the 401(k) value by the distribution factor.
Once you do the math, you'll know what the amount of your RMD will be.
Don't get confused, though: There's a separate set of tables designed for heirs, and they're much different from the tables for original 401(k) accountholders. Below are the factors for 401(k) RMDs.
How do I calculate the RMD for an inherited 401(k)?
This chart tells you how many years you're expected to live based on your current age. For instance, if you'll turn 58 this year, then the IRS table says your remaining life expectancy is 27.0 years.
An example will help make it easier to see how this works. Say you'll turn 58 in 2019 and inherited a 401(k) from a parent who passed away during 2018. As of Dec. 31, 2018, the inherited 401(k) was worth $135,000.
Following the three steps, you first take the $135,000 value of the inherited 401(k) and divide it by the factor for a 58-year-old, which is 27.0. $135,000 divided by 27.0 is $5,000, so that's how much you'll have to withdraw in 2019 to meet the stretch 401(k) requirements.
That's easy enough. The following year, things get a little trickier. To calculate the 2020 RMD, measure the value of the inherited 401(k) at the end of 2019, and then divide it by a factor that reflects your updated remaining life expectancy. To do that, start with the 27.0 factor for 2019 and then subtract 1 from it. The answer is 26.0, which is your factor for 2020.
Don't make the typical mistake of going back to the life expectancy table to find factors in future years. You'll get the wrong number if you do. In the example above, if you took the factor for a 59-year-old in 2020, you'd get 26.1 rather than 26.0. That could result in penalties for taking out too small of a withdrawal.
What are the most common mistakes people make with inherited 401(k)s?
The traps that both 401(k) accountholders and their heirs fall into the most often include the following:
- The beneficiary designation is omitted or out of date, failing to name the intended person to inherit the 401(k) assets. This often occurs because of a marriage, divorce, death, or birth of a child that makes an old beneficiary designation no longer the best choice for inheriting the 401(k).
- The heir takes a lump-sum distribution from the inherited 401(k), unnecessarily paying the most tax possible.
- The heir tries to take advantage of stretch 401(k) treatment but miscalculates the RMDs, incurring penalties and getting in trouble with the IRS.
It's not hard to avoid these mistakes as long as you're aware of them. The problem is that 401(k) inheritances come at a difficult time, and many grieving people don't do what they need to do in order to follow the rules correctly.
Don't waste your 401(k) inheritance
An inheritance is always bittersweet, because it involves the death of a loved one. But in order to honor the memory of the person who named you as beneficiary of a retirement account, you owe it to yourself to make the most of your 401(k) inheritance. Learn these rules, and use favorable stretch 401(k) and spousal rollover options if you can, and you'll be best able to use your inherited 401(k) throughout your lifetime.
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