What Happens if I Inherit Someone Else's 401(k) Account?

When someone dies with money left in a 401(k) plan, the account ownership passes to the person named as a beneficiary. This is never a fun way to come into money. But knowing the rules for handling the account can help you keep more of it in your hands rather than sharing an excess with the Internal Revenue Service.

Distribution Taxes

No matter how old you are or how old the person from whom you inherited the 401(k), you're allowed to take the money out whenever you want without paying an early withdrawal penalty. The IRS exempts beneficiary distributions from the 10 percent additional tax on early withdrawals. However, you're still responsible for paying taxes on the distributions. If you withdraw a large amount in a single year, you could find yourself in a higher income tax bracket.

Distribution Options

As with other retirement accounts, the IRS requires 401(k) beneficiaries to remove the money in a timely fashion. You have the option of either removing the entire 401(k) balance by the end of the fifth year after the year of the previous owner's death, or taking minimum distributions every year. Under the first option, no distributions are required until the end of the fifth year. If you use the second option, the required withdrawals start in the year after the person died and continue every year until the account is emptied. If you don't take out the required amount, you get hit with an extra 50 percent tax on the portion that you should have withdrawn but didn't.

Spousal Benefits

If you inherited the 401(k) plan from your late spouse, you have additional options for withdrawals. Besides the options available to all beneficiaries, spouses can treat the 401(k) plan as their own. This allows you to mix the money with your own existing retirement accounts. For example, you could roll the inherited 401(k) into your own IRA. You also could base the distribution on your own age, which would prolong the time until you'd have to start taking money out of the account.

Employer Plan Rules

The decedent's employer might have additional requirements for getting the money out of the 401(k) plan within a short period of time. For example, you might be required to take the money out of your plan within a year, potentially depriving you of future tax-sheltered growth of the money in the account. To avoid this, any beneficiary, including non-spouses, can transfer the money to a beneficiary IRA. Unlike a rollover, in a direct transfer your 401(k) plan administrator moves the money directly to the beneficiary IRA, rather than paying it to you to redeposit in your account.