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Inheriting A 401k Plan: Taxes, Laws And Rules
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Published: December 11, 2006
These days, with the future state of social security in the United States is in such question, most people have cause to worry about the quality of their lives after reaching a retirement age. The employer-sponsored 401k offers a tremendous opportunity for workers to invest and save for their retirement.
Named after a section of the U.S.
Internal Revenue Code (IRS), 401k plans allow for investments, typically an assortment of mutual funds, which come with a built-in income tax deferment on all the saved money and its earnings until it is first withdrawn.
Whether it is your spouse or your third-cousin who dies, once you find yourself as a beneficiary in a will inheriting a 401k, there are certain steps needed to be taken as soon as life surrounding the death works its way back toward normal. Unless you are an account or other tax professional, the first step would be consulting with such a person to determine how exactly to maximize the earnings of what you are entitled.
Each 401k is unique with its own set of rules and laws, but you most likely will be forced to take the money out of the account all together; this process is known as a lump sum distribution. With lump sum distribution employers avoid the problem of having to monitor an account of an employee who no longer works there.
Next, the 401k inheritance taxes will kick in; the lump sum you receive will be subject to all the local, state and federal income taxes applicable by law. However, you will not have to pay the early withdrawal taxes you would if you withdrew money before the age of 59 ½, the age at which account holders are normally first permitted to take money out without penalty.
If you are the spouse of the deceased, the rules are slightly different. By asking for a direct rollover, where the plan sponsor (employer) transfers the money directly into an existing IRA of yours, you can avoid the income taxes. Make sure you ask for a direct transfer, though; otherwise, if you receive the check yourself, you will find yourself sinking under more complicated IRS restrictions and taxes.
Any beneficiary to such an inheritance should be able to stretch out the payments throughout a period of years to limit the amount that would otherwise be lost to taxes. If the deceased already was receiving payments from the plan, you usually can continue receiving them, either at the same rate or faster, but not slower over a longer period of time.
If the account holder had not already set up a payment schedule, the beneficiary has more options. Again, it depends on the plan, but you will likely have until December 31 of the year the person died to decide if you want to receive the payments over a five year span, or stretched throughout the remaining years of your calculated life expectancy. If the beneficiary makes no specifications, the plan defaults to life expectancy for a spouse and five-year method for a non-spouse. In most cases, a beneficiary who is a spouse has more options than a non-spouse.
Again, inheriting a 401k can be tricky; you suddenly become a beneficiary to a sum of money, but if you make the wrong moves, the amount you actually see could be far less than it could have been with more careful planning. Calculating these strategies is not something which you want to do without the help of a trained professional. With help at your side, you have someone who can warn you about such financial decisions that can jeopardize your inheritance.
Sources:
401(k). Wikipedia online encyclopedia. 28 November 2006. 10 December 2006. <http://en.wikipedia.org/wiki/401(k).>
Tax Issues When You Inherit a 401k. 401k Help Center.com. 2006. 10 December 2006. <http://www.401khelpcenter.com/401k_education/i nheriting_401k.html.>
Named after a section of the U.S.
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Whether it is your spouse or your third-cousin who dies, once you find yourself as a beneficiary in a will inheriting a 401k, there are certain steps needed to be taken as soon as life surrounding the death works its way back toward normal. Unless you are an account or other tax professional, the first step would be consulting with such a person to determine how exactly to maximize the earnings of what you are entitled.
Each 401k is unique with its own set of rules and laws, but you most likely will be forced to take the money out of the account all together; this process is known as a lump sum distribution. With lump sum distribution employers avoid the problem of having to monitor an account of an employee who no longer works there.
Next, the 401k inheritance taxes will kick in; the lump sum you receive will be subject to all the local, state and federal income taxes applicable by law. However, you will not have to pay the early withdrawal taxes you would if you withdrew money before the age of 59 ½, the age at which account holders are normally first permitted to take money out without penalty.
If you are the spouse of the deceased, the rules are slightly different. By asking for a direct rollover, where the plan sponsor (employer) transfers the money directly into an existing IRA of yours, you can avoid the income taxes. Make sure you ask for a direct transfer, though; otherwise, if you receive the check yourself, you will find yourself sinking under more complicated IRS restrictions and taxes.
Any beneficiary to such an inheritance should be able to stretch out the payments throughout a period of years to limit the amount that would otherwise be lost to taxes. If the deceased already was receiving payments from the plan, you usually can continue receiving them, either at the same rate or faster, but not slower over a longer period of time.
If the account holder had not already set up a payment schedule, the beneficiary has more options. Again, it depends on the plan, but you will likely have until December 31 of the year the person died to decide if you want to receive the payments over a five year span, or stretched throughout the remaining years of your calculated life expectancy. If the beneficiary makes no specifications, the plan defaults to life expectancy for a spouse and five-year method for a non-spouse. In most cases, a beneficiary who is a spouse has more options than a non-spouse.
Again, inheriting a 401k can be tricky; you suddenly become a beneficiary to a sum of money, but if you make the wrong moves, the amount you actually see could be far less than it could have been with more careful planning. Calculating these strategies is not something which you want to do without the help of a trained professional. With help at your side, you have someone who can warn you about such financial decisions that can jeopardize your inheritance.
Sources:
401(k). Wikipedia online encyclopedia. 28 November 2006. 10 December 2006. <http://en.wikipedia.org/wiki/401(k).>
Tax Issues When You Inherit a 401k. 401k Help Center.com. 2006. 10 December 2006. <http://www.401khelpcenter.com/401k_education/i nheriting_401k.html.>
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