If you’ve inherited a 401(k) from a parent, you likely have questions about your options for the account and the tax impact. Luckily, non-spouse beneficiaries usually have some control over how to manage an inherited 401(k) plan. However, as part of the Secure Act, most adults who inherit a 401(k) from a parent must take the money in 10 years. Depending on your financial position and life stage, the short payout period could really complicate your tax situation. After inheriting a 401(k) from a parent, you may be looking to balance prolonged investment growth with tax mitigation on distributions.
Important planning notes: The IRS has proposed changes to previous guidance regarding RMDs during the 10-year window. As drafted in 2022, the IRS’ changes would impact certain non-spouse beneficiaries by requiring distributions in years 1 to 9 in addition to withdrawing all the funds in year 10 if the decedent was subject to RMDs when they died.
In July 2023, the IRS released a notice extending the penalty waiver on missed distributions for 2023 (if missed solely due to pending guidance) and indicated that final guidance won’t come until 2024.
Because the changes are not yet finalized, this article is written under the existing assumptions which do not require RMDs during the 10-year window.
Overview: what beneficiaries need to know after inheriting a 401(k) from a parent
When you inherit a retirement account like a 401(k), distributions generally follow the same tax treatment as would apply to the original account holder. The big difference is the distribution period. There’s also no one best withdrawal strategy for all beneficiaries. Your current tax rate relative to the future is an important consideration. Similarly, any life changes in the next 10 years, like sending the kids to college or retiring, can also impact your strategy.
The options for an inherited IRA differ somewhat from an inherited 401(k). If you’ve inherited an IRA outright, you’ll usually have full control over the timing of disbursements within the 10-year window. When inheriting a 401(k), particularly from a parent, you may be subject to plan specific rules. You’ll need to know if there are any other beneficiaries and work with the executor of the estate and 401(k) plan sponsor to discuss your payout options.
If you inherited a 401(k) from a parent, here’s when you need to take the money
The Secure Act created two classes of designated non-spouse beneficiaries: eligible designated beneficiaries (not subject to the 10-year rule) and non-eligible designated beneficiaries. This article focuses on the distribution rules for non-eligible designated beneficiaries as that is most common.
After inheriting a 401(k) from a parent, your primary decision is when to take the money. As a non-spouse beneficiary, funds from an inherited 401(k) plan must be taken by the end of the 10th year following the year your parent passed away. This is called the 10-year rule.
There are three exceptions to the 10-year rule (eligible designated beneficiary):
- Minor beneficiaries have until they reach the age of majority (21) before the 10-year payout period begins
- The 10-year rule doesn’t apply to beneficiaries less than 10 years younger than the decedent, or
- If the beneficiary is disabled. Beneficiaries qualifying for exception #2 or #3 can take the funds over their lifetime, typically using the old required minimum distribution rules (also called a stretch IRA).
Do beneficiaries pay tax on an inherited 401(k)?
When you inherit a retirement account like a 401(k), distributions generally follow the same tax treatment as would apply to the original account holder. So in the majority of cases, beneficiaries pay regular income tax on distributions from an inherited 401(k). This would be the case if your parent made before-tax contributions to a 401(k), as most people do. This could push you into a higher marginal tax bracket, trigger the 3.8% Medicare surtax, or cause the loss of other income-driven tax deductions.
If you inherit a Roth 401(k), distributions may be tax-free if your parent first began making contributions to their “designated Roth account” at least five years before you begin your own withdrawals.
Ways to reduce tax on distributions from an inherited 401(k) by strategically timing when to take the money
A decade isn’t a tremendous amount of time to spread distributions from a sizable 401(k) plan. The best strategy for you will depend on several factors. Consider your financial situation, upcoming life changes, and the size of the account relative to your income. Here are some strategies, though you’ll want to discuss with your CPA and financial advisor before making any decisions.
If your tax bracket is lower this year, but likely to increase
If you’re in a low (or substantially lower) tax bracket this year relative to where you expect to be in the near future, here are some options to consider.
- Take the money as a lump sum. If you’re in a very low tax bracket this year, but expect that to change next year, it may make sense to think about taking the money sooner than later. If you’ve been laid off or suffered a big pay cut, you might need the funds.
- You don’t need the money, but want the most flexibility. If you don’t need the money for living expenses now, you can reinvest the cash (after-tax) in a brokerage account.
- Convert an inherited 401(k) to an inherited Roth IRA. Another option for individuals in a low tax bracket this year who don’t need the money now is converting an inherited 401(k) to an inherited Roth IRA. This option is unique for beneficiaries of 401(k) plans; individuals who inherit a traditional IRA aren’t able to convert to a Roth IRA. Plan permitting, converting a pre-tax inherited 401(k) to an inherited Roth IRA means you’ll pay ordinary income tax on the amount you convert that year. The funds grow tax-deferred in your inherited Roth IRA and can be withdrawn tax-free. Keep in mind, the 10-year rule still applies. But now the account can grow as long as possible without triggering a negative tax event later on.
If your tax bracket is relatively stable and you don’t expect major changes in the next 10 years
If you’re a mid-career working professional, you might not expect any major changes to your tax situation. Assuming you also don’t have any big life events on the horizon, you may wish to consider the following options.
- If the inherited 401(k) is on the smaller side, or consists of all tax-free Roth contributions, consider letting it grow tax-deferred. Is the 401(k) likely to wreak havoc on your tax situation? If not, consider rolling it over to an inherited IRA and letting the money grow until you’re nearing the end of the 10-year period. If you’ve inherited a 401(k) with Roth contributions, you’ll likely want to let the money grow as long as possible as the withdrawals are tax-free.
- Spread withdrawals over the 10-year period. On the other hand, if you’ve inherited a sizable 401(k), it might be best to spread distributions out over the 10-year payout period. This will help you avoid any extreme changes to your tax situation in one year. If you don’t need the money, you can always reinvest it in a brokerage account after paying tax.
If your tax bracket is high and you expect a decrease within 10 years
- Consider waiting until your tax rate decreases to begin distributions. If you’re planning to retire or move to a state with low/no income tax, consider holding off on taking money from your inherited 401(k). Especially for residents of high tax states like New Jersey or California, the tax savings may be considerable if moving to a state without an income tax, like Florida. As with everything in investing and tax planning, this strategy carries risk. If your plans change, tax law changes, market volatility, etc. can all affect your total net after-tax proceeds.
Other considerations after inheriting a 401(k)
What else did you inherit from your parent?
When deciding when to take money from an inherited 401(k), consider the other assets you inherited. The tax treatment of an inheritance depends on the type of asset you inherit. For example, an inherited IRA is taxed differently than an inherited home or brokerage account, which receive a step-up in basis.
Ultimately, what you should do with an inherited 401(k) partially depends on the details of the rest of your inheritance.
Major life changes can impact your tax situation, too
Your salary isn’t the only input that matters when figuring out your tax liability and possible planning strategies.
Planning to apply for financial aid? Try to avoid big increases to your income that will be reported on the FAFSA. The FAFSA uses the prior, prior year’s tax returns.
Under current tax law, the tax rate(s) you pay when recognizing long-term capital gains stems from your taxable income. If your taxable income increases, it can push you into a higher tax bracket for long-term capital gains. It could also trigger the 3.8% Medicare surtax among other negative consequences.
If you’re planning selling an investment property, home where all or part of the proceeds is taxable, business, or other major asset sale, you’ll likely want to consider capital gains tax as a factor in your distribution strategy.
Medicare part B and D premiums are calculated using your modified adjusted gross income (MAGI) from your prior, prior year’s tax returns. A $1 increase in your MAGI can cause Medicare premiums to increase substantially.
For example, a married couple filing jointly would pay $1,387 more per year (combined) for Medicare Part B premiums in 2020 if income from their 2018 tax return increased to $175,000 from $174,000.
Required minimum distributions or withdrawals from your pre-tax retirement accounts
As you’re considering a tax-efficient strategy for an inherited 401(k), also consider tax planning solutions for your own retirement accounts. Required minimum distributions (RMDs) from your traditional IRAs and 401(k) plans now begin at age 73 – but that doesn’t mean you should always wait.
Large taxable distributions or RMDs from your retirement accounts will also increase your taxable income, so it’s important to plan your strategy while considering your entire situation. To reduce the tax impact, you may want to strategies like Roth conversions or a blended withdrawal strategy.
Investing or reinvesting money from an inherited 401(k)
Delaying distributions from an inherited 401(k) carries investment risk, which is another topic entirely. Strategies for investing an inheritance should be a factor in your decision. After all, the stock market doesn’t just go up. Whether you decide to keep the money in the 401(k) (plan permitting), request a rollover to an inherited IRA, or do a Roth conversion, you’ll need to ensure the funds are invested according to your risk tolerance and maximum 10-year payout period.
Help deciding what to do with an inherited 401(k)
Figuring out what to do with an inheritance can be a complex process, so it’s important to have the right team in place. If your parent was working with a financial advisor and you don’t feel he/she is a good fit for you, consider finding your own fiduciary advisor to help you navigate your options. Please contact us to discuss your situation.