When you die and leave behind a 401(k) account, your beneficiary will have to deal with the tax consequences. The Internal Revenue Service rules offer options for plans regarding the payout choices to the beneficiary. The payout terms of the plan and your relationship to the deceased participant will affect your tax liability.
Upon your death, your beneficiary may receive a lump sum or extended payout depending on your 401(k) plan's rules. Your spouse may also roll the inherited 401(k) over to his or her retirement account.
Lump Sum Payout Option
When a 401(k) plan participant dies, many plans for administrative convenience specify that beneficiaries receive all the money in the account in a lump sum. IRS rules require that the lump sum must be paid no later than Dec. 31 of the year following the participant’s death. If a participant died in 2018, for example, the money in the 401(k) must be paid to the beneficiary by the end of 2019.
Extended Payout Option
IRS rules permit plans to offer extended payouts but don’t require this. Plans with extended payouts can distribute the money to the beneficiary in annual installments spread over the beneficiary’s life expectancy as defined in IRS longevity tables. As with a lump sum payout, distributions to the beneficiary must begin by Dec. 31 of the year following the participant’s death.
If you don’t take the lifetime payout, you must close the account within five years. But if the participant was over 70½ and already receiving required minimum retirement distributions prior to death, distributions to the beneficiary follow the same schedule as would have been used had the participant lived.
Spouse Rollover Option
A spouse who is the 401(k) beneficiary has options not available to other beneficiaries. A spouse can roll the inherited 401(k) money over to his or her own tax-deferred individual retirement arrangement and avoid taxes and penalties. Other beneficiaries don’t have this option.
If the deceased participant was 70½ and had started taking mandatory minimum distributions, a spouse beneficiary’s decision to roll over the account to his or her own IRA halts the mandatory distributions until the spouse beneficiary turns 70 ½. If the plan permits extended payouts, a spouse beneficiary has the option to leave the money in the 401(k) until the year the deceased participant would have turned 70½.
Tax Implications of Payout
Any money a beneficiary receives from the inherited 401(k) is taxable in the year it is paid. The 401(k) administrator will report the distribution to the IRS under the beneficiary’s name and Social Security number, not those of the deceased participant.
Distributions from a 401(k) are taxed as ordinary income. The beneficiary is responsible for reporting the distribution and paying the income taxes on it. But distributions to a beneficiary from an inherited 401(k) account are exempt from the 10 percent early withdrawal penalty regardless of the beneficiary’s age.
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