Inheriting a 401(k) vs. an IRA

by Emily Beach

    Inheriting money can have negative tax consequences for some heirs.

    A young woman holding a pen, doing her taxes image by Christopher Meder from Fotolia.com

    Both 401(k) and individual retirement accounts make it easier to save toward retirement. Although these accounts have similar purposes, each offers distinct benefits and drawbacks in terms of taxes, return, contribution levels and access. When an account holder passes away, 401(k)s and IRAs also have different advantages and disadvantages for the people who inherit them, from how they are taxed to how they are structured.

    According to The Wall Street Journal, 401(k) plans offer little flexibility when it comes to who inherits the account after the owner's death. Regardless of any agreements between the account holder and his heirs, the 401(k) automatically becomes the property of the surviving spouse. The spouse gets the account regardless of who the account owner named beneficiaries, and regardless of any prenuptial agreement.
    The only way that the spouse would not inherit the 401(k) would be if the spouse signed an agreement refusing the money. In that case, it would pass to the children or next of kin.

    There is far greater choice when it comes to who inherits an IRA. According to The Wall Street Journal, the account goes to whomever is specified as the beneficiary, regardless of whether the account holder was married.

    The most important thing to do when you inherit a 401(k) or an IRA is immediately contact the account manager or account custodian and tell them not to liquidate the account. If you allow them to liquidate it, or if you accept a check for the money in the account, you will immediately owe taxes on the money, and all benefits of these accounts are lost.
    If you are one of multiple beneficiaries for an IRA or 401(k), you must inform the account manager or custodian how you will divide the account by Dec. 31 of the next year. If you don't, the distributions will be based on the age of the oldest beneficiary, which can lead to significant tax increases for younger beneficiaries.

    The taxes you pay and the minimum distributions you're required to take on your inheritance can vary dramatically based on the age of the account holder when he died. If an IRA owner was 70.5 or older when he passed away and if he had already begun taking required mandatory distributions, the heir may choose to continue taking distributions on the existing schedule, or to spread the distributions out over his own life expectancy. If you are roughly the same age as the deceased, it makes sense to follow his withdrawal schedule. If you are much younger, consider switching to a longer withdrawal schedule spread over your own life expectancy.
    If the deceased was younger than 70.5, you can either take required minimum withdrawals based on your own life expectancy or liquidate the account within five years. If you can afford to wait for the money and withdraw it over many years, you will probably save a lot in taxes and penalties.
    Before 2007, people who inherited a 401(k) were forced to liquidate the account within five years, which often resulted in severe tax burdens for the heirs. Only spouses had the option of rolling an inherited 401(k) into their own IRA and spreading out the taxes over time. Since 2007, anyone who inherits a 401(k) may roll it over into an inherited IRA, which has the same minimum withdrawal and tax implications as a traditional IRA.

    Photo Credits

    • A young woman holding a pen, doing her taxes image by Christopher Meder from Fotolia.com

    About the Author

    Emily Beach works in the commercial construction industry in Maryland. She received her LEED accreditation from the U.S. Green Building Council in 2008 and is in the process of working towards an Architectural Hardware Consultant certification from the Door and Hardware Institute. She received a bachelor's degree in economics and management from Goucher College in Towson, Maryland.

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