You work all your life for the day you can retire, putting money aside to fund your golden years. If you’ve put that money into a retirement account like a 401(k), you can only hope it will keep you cozy as you relax and travel. But what happens if you die before you deplete that money? The money in your 401(k) is still yours, but you won’t be around to spend it all. That’s where your designated beneficiary comes in. Your 401(k) will go to the person listed as the beneficiary, which probably is a spouse. But what that survivor can do with the inherited 401(k) depends on that person’s relationship to you.
Restrictions on Inherited 401(k) Rollovers
If your 401(k) is designated to go to your spouse when you die, the options are much broader. Your surviving spouse can usually roll the money into an IRA if he wants. He can also choose to leave the funds in place for later, take the money in a lump-sum payment or slow that lump sum down, withdrawing it over five years. But the 401(k) beneficiary rules for non-spouses are different. Other beneficiaries can’t roll the funds over as they wish. They’re restricted to either leaving the 401(k) in place, removing it as a lump sum or taking distributions from it over a five-year period.
But even though there are general guidelines that apply to inheriting a 401(k), each employer can set rules as to how distributions will be handled. These may be driven by the plan provider’s guidelines, so don’t blame the employer if the rules are too restrictive. If you aren’t sure how your employer-provided 401(k) will be handled in the event of your death, see your HR department or track down any documentation you were given when you signed up for your plan. This may also be a good time to double-check to make sure you have the right beneficiary listed.
Inherited 401(k)s and Taxes
When it comes to inheriting retirement funds, it’s important to pay close attention to what will happen at tax time. A traditional 401(k) is funded using money that has not yet been taxed, which means taxes are due when the money is taken out. For your loved ones, that means that the money they take from your 401(k) will be taxed as ordinary income, throwing them into a higher tax bracket. For this reason, many survivors feel that it can help to take the funds out over a five-year period, rather than all at once.
Due to the tax consequences, many spouses opt to roll the funds into another account, such as an IRA. If the spouse has an existing IRA or has inherited one from the deceased, the money can be rolled over into that account. However, if there is no account already in place, a new IRA can be set up for the spouse so that the money can be rolled into that. At this point, the money will be in the new account, subject to the tax rules of that IRA account at the time of withdrawal.
Roth Versus Traditional IRA
In addition to the 401(k) beneficiary rules, it’s important for your spouse to understand the options when it comes to rolling funds into another type of retirement account. If your 401(k) is a traditional one, that means the money went into the account before taxes with the understanding that you’d pay taxes on it when you took the money at retirement. If you roll the funds into a traditional IRA, the same rules will apply. When your survivor accesses the funds, that money will be subject to taxes, since they weren’t paid originally.
Things get a little more complicated if your spouse chooses to move the money from a traditional 401(k) to a Roth IRA. With a Roth IRA, contributions are made with after-tax dollars, with the benefit of being able to enjoy tax-free distributions at retirement. Your employer’s plan will need to allow this type of rollover, but if you have the go-ahead, setting it up may simply be a matter of checking a box to say you want to roll the money into a Roth IRA rather than a traditional IRA. If not, the brokerage where your spouse set up the Roth IRA account should be able to help you roll the funds to a traditional IRA, then convert it to a Roth IRA. This is known as creating a “backdoor Roth IRA,” and it will require your spouse to pay income tax on the contributions, since they weren’t paid when you put them into your 401(k).
Rolling Over Your 401(k)
There’s a right way and wrong way to move a 401(k) to an IRA, and your surviving spouse will want to do it the right way. Cashing out the fund is the wrong way, since it could result in taxes of up to one-third of your balance. She’ll first need to set up an IRA account, preferably shopping around to find the one with the lowest fees. She can then go to the plan sponsor – your employer – and ask for a “direct rollover.” This will ensure that the money is moved from the old account to the new one, rather than writing a check for the account balance.
She needs to make an important decision when choosing an IRA provider. There are some brokers who manage everything for clients, creating a diversified profile that needs no hands-on management. However, if she’s good with investments, she may instead choose to go with a broker that allows her to actively manage her portfolio on a regular basis. Whichever choice she makes, she’ll need to regularly check in on the plan’s performance to ensure it continues to grow.
401(k) Spouse Takeover
Instead of rolling an inherited 401(k) into an IRA, your spouse has another option. This isn’t open to beneficiaries who aren’t married to you, so it’s worth considering if the person inheriting your 401(k) is your spouse. You’ll need to check your 401(k) beneficiary rules with your employer to make sure this is an option, but it’s well worth investigating if your beneficiary is your spouse.
If your spouse is inheriting retirement funds you’ve put in place, and it’s within the guidelines of your employer’s policy, things should go smoothly if something happens to you. Legally, the funds in your 401(k) go to your spouse, even if you’re legally separated, unless your spouse signs a document giving up his rights to the money. If you’re divorced, the details of what happens to your 401(k) should be in your divorce paperwork. After your death, your spouse can either keep the funds in the account, roll it over or cash it out.
IRA Rollover to 401(k)
If your survivor is inheriting retirement funds in an IRA, the rules are similar, but are also subject to an employer’s guidelines. Surviving spouses can simply take over the account, cash it out or roll it over. Other survivors can only cash the account out. However, your spouse may want to roll the funds over into a 401(k) if, say, she has an existing 401(k) account through an employer.
As with an inherited 401(k), rolling over an IRA simply means giving the account information to the plan administrator. You’ll request a direct transfer, which will avoid the tax consequences of cashing the funds out. The plan administrator likely has a process in place for moving the funds, but it’s important to check to ensure your IRA plan adviser allows this sort of transfer.
Video of the Day
- The Motley Fool: How to Inherit a 401(k)
- 401k Help Center: Tax Issues When You Inherit a 401k
- Investopedia: DEFINITION of 'Roth IRA'
- Investopedia: What Happens to Retirement Accounts If a Spouse Dies?
- Good Financial Cents: SEARCH Can You Rollover Your 401k to a Roth IRA?
- RothIRA.com: Can you convert to a Roth IRA?
- NerdWallet: 401(k) Rollovers: A Quick Start Guide