If you have not exhausted the funds in your 401(k) plan upon your death, your beneficiary will inherit the balance in your account. Although beneficiaries typically pay income taxes on 401(k) proceeds, the funds are not actually taxed until the money is withdrawn from the plan. Tax treatment varies, depending on whether you’re a surviving spouse or a nonspouse beneficiary.
Tax Considerations of Inherited 401(k)s
When addressing how an inherited 401(k) will be taxed when the death of the accountholder occurs, there are three primary considerations:
- The relationship of the 401(k) accountholder to the beneficiaries.
- The age of the 401(k) accountholder at death.
- The parameters of the specific 401(k) plan (different plans have different terms).
Types of 401(k) Beneficiaries
Generally, beneficiaries of 401(k) plans are family members of the accountholder. You can designate one beneficiary or multiple beneficiaries, and you can split the account assets any way you want. For example, you may choose one primary beneficiary, such as your spouse, who receives 100 percent of the proceeds upon your death. Or you may choose six primary beneficiaries – your spouse and your five children – designating, for example, that your spouse receives 50 percent of the plan proceeds, and each child receives 10 percent.
If one of your multiple primary beneficiaries dies before you, assets are divided among the remaining beneficiaries. Contingent beneficiaries are the people you choose to inherit your 401(k) plan if all of your primary beneficiaries predecease you.
Although you do not have to designate your spouse as a 401(k) beneficiary, some plan providers require your spouse to complete a spousal consent form. On this form, your spouse confirms that you have not named him or her as your 401(k) beneficiary and consents to your choice.
Surviving Spouses Have More Options
As the named beneficiary of your 401(k) account, spouses have more options for receiving the benefits, which include treating the 401(k) as their own account. In contrast, nonspouse beneficiaries do not have the option of treating the 401(k) as their own account and must make different account management choices.
A spouse who inherits a 401(k) has the following options:
- Assume ownership of the plan. As the new owner, a spouse may continue to make contributions and withdrawals to the plan. If the spouse has not yet reached the age of 59 ½, any withdrawals (called distributions) are assessed a 10 percent early distribution federal income tax penalty, and the spouse must begin making required minimum distributions at age 70 ½. If the spouse does not take the required minimum distributions, the IRS levies a 50 percent excise tax on the amount that should have been withdrawn. Any nondeductible distribution is included in the spouse’s gross income and taxed accordingly.
- Roll over the 401(k) account into another retirement account. If the inherited 401(k) is subject to a mandatory lump-sum distribution, surviving spouses can avoid the income tax penalty simply by rolling over the 401(k) to their own 401(k) plan within 60 days after their spouse’s death.
- Maintain the status as account beneficiary. If a spouse dies before reaching the age of 70 ½, and the surviving spouse has not yet reached the age of 59 ½, the survivor can delay receiving funds in the account until such time as the deceased spouse would have reached age 70 ½. When the surviving spouse reaches the age of 59 ½, the account can be rolled over without penalty.
- Choose the 5-year rule option. If the plan owner dies before reaching age 70 ½, the surviving spouse can elect to take a total withdrawal from the account by Dec. 31 of the fifth year following the spouse’s death.
Options for Nonspouse Beneficiaries
If you’re the beneficiary of a 401(k) but you’re not the surviving spouse, your options are a little narrower. You cannot treat the inherited 401(k) as your own account, and you cannot roll over the funds into your own account.
Your options include:
- Taking a full withdrawal. If you choose to take the full withdrawal, you’ll pay income tax on the distribution.
- Choosing the 5-year rule option. If the plan owner died before reaching age 70 ½, you can defer taking the full withdrawal from the account by Dec. 31 of the fifth year following the spouse’s death.
- Receiving minimum distributions. By treating the 401(k) as an inherited account, you may be able to begin taking minimum withdrawals from the account by Dec. 31 in the year following the plan owner’s death, depending on the plan parameters.
Taxing 401(k) Charity Beneficiaries
It’s perfectly permissible to donate the proceeds in your 401(k) to a charitable organization upon your death. If you’re married, you’ll likely have to get your spouse’s consent in writing on the spousal consent form provided by your plan administrator. You can also designate a charity as one of your beneficiaries, without having to appoint a spouse, family member or the charity as a sole beneficiary. Your estate will still have to pay estate taxes on any amount that exceeds the $11.4 million exclusion, but the estate will receive a tax deduction for the charitable contribution to offset any estate taxes owed.
The charity you designate as your 401(k) beneficiary receives these benefits:
- Bypassing probate. Typically, as long as you’ve properly set up a charitable organization as your beneficiary, the charity has immediate access to your 401(k) funds upon your death without waiting for the probate process.
- Receiving tax-free distributions. Qualifying charitable organizations will not have to pay income tax, which gives them the total donation of your 401(k) funds.
401(k) Death Distributions With No Beneficiary
One perk of having a 401(k) plan is that your named beneficiary generally will not have to wait until your estate is probated to access the funds in the account. If you failed to designate a beneficiary, or if your beneficiary predeceases you before you add a new beneficiary, a 401(k) death distribution with no beneficiary means that your 401(k) account becomes part of your estate that is subject to probate.
Estate Tax for Inherited 401(k)
The 401(k) beneficiary rules after death of the plan owner include the requirement for beneficiaries to pay income tax on the amount of the withdrawals they make from the account. Spouses are exempt from paying estate taxes on an inherited 401(k) because of the unlimited tax-free spousal gift amount allowed by the IRS.
Nonspouse beneficiaries will not have to pay estate taxes on an inherited 401(k), because the estate is actually responsible for paying estate taxes. Even then, the estate only pays taxes when a decedent’s estate exceeds $11.4 million. This lifetime tax exclusion is reduced by any gift amounts the decedent made during his lifetime.
401(k) Plans Have Different Terms
Because there are many types of 401(k) plans, there’s not a one-size-fits-all checklist for beneficiaries. To decipher the legalese of your inherited 401(k) and understand your options, a visit to your financial planner or tax attorney may be in order.
- U.S. News and World Report: How to Pick a Beneficiary for Your 401(k) Plan
- Interactive Brokers: Spousal Consent Form
- Debt.org: What to Do with Retirement Accounts After Death
- IRS: Publication 575
- IRS: Retirement Topics - Beneficiary
- The Motley Fool: 401(k) Inheritance - Your Complete Guide
- IRS: Estate Tax
- Fidelity Charitable: Donating Retirement Assets