��Ѩ��Ƶ

If you expect to inherit a 401k plan from a parent or spouse, it’s important to understand the potential tax consequences and what strategies you can use to minimize them. Unlike inherited real estate, where there is often a “step-up” in cost basis that allows the recipient to generally avoid paying any federal taxes, assets inherited through a 401k may be considered taxable income.

How those assets are taxed depends on a number of factors, including

●      The age of the 401k account holder when they passed

●      The relationship between the beneficiary and the account holder

●      The age of the person who is inheriting the 401k

When you’ll have to pay federal income taxes will depend on how you decide to receive the inherited 401k plan.

When someone passes away, their 401k becomes part of their estate, but the rules that govern how profits and withdrawals from that 401k are taxed generally stay the same. And because a traditional 401k is funded with pretax dollars, the beneficiary will usually have to pay the taxes on withdrawals. The exception is a Roth 401k, which is funded with after-tax dollars, so withdrawals are typically fully tax-free.

The amount paid is based on the ordinary income tax rate of the beneficiary, not of the original owner of the 401k.

If you choose to keep the inherited 401k account, there are a few withdrawal rules you should keep in mind.

A required minimum distribution is generally the minimum amount you must withdraw from your 401k retirement plan each year starting at the age of 72 (or 73 if you’re turning 72 in 2023 or later). You can withdraw more than this amount but delaying a distribution will incur a tax penalty of up to 25% of the RMD.

A hardship distribution, or hardship withdrawal, allows you to access your 401k assets immediately if you have a substantial financial need for the funds. Any 401k withdrawal due to hardship is taxed and limited to only what will cover your immediate need. To qualify for a hardship distribution, you must satisfy the necessary IRS requirements.¹

Unless it’s due to a qualified hardship, any 401k withdrawal made before the age of 59½ will automatically incur a 10% early distribution penalty. For instance, if you withdraw $10,000, you could end up paying $1,000 on top of the ordinary income tax. This is a heavy fee that many choose to avoid by waiting until they pass the age requirement.

If you inherit a 401k from your spouse and are younger than age 59½, you have a number of options:

●      Do nothing: You don’t have to do anything with an inherited 401k. You can just leave it as is and begin taking regular distributions. You will have to pay taxes on those distributions, but you won’t have to pay the 10% early withdrawal penalty.

●      Take a lump-sum payment: With this option, you receive all the 401k distribution funds at once. You will pay income tax on the full amount, but you will not incur a 10% early withdrawal penalty (assuming the money was used for medical expenses or college tuition costs). Be aware that taking a lump-sum distribution could move you into a higher tax bracket, depending on your current income.

●      Transfer ownership: If you are the sole beneficiary of an inherited 401k, you can transfer the asset into your own 401k or into an IRA. However, if you withdraw money from this account, you may be subject to a 10% early withdrawal penalty.

●      Open an inherited IRA: This option allows you to roll over funds directly from an inherited 401k into a new inherited IRA in your name. You can then take distributions based on your life expectancy and avoid the 10% early withdrawal penalty, even if you are younger than 59½.

If you are the beneficiary spouse of a traditional 401k and are older than 59½, you will generally avoid the 10% early withdrawal penalty no matter which of the above options you choose.

And if your spouse was already taking the required minimum distribution each year from their 401k when they passed away, you have the choice to continue taking them or delaying them until you turn 73. However, if you are already age 73 or older, you will usually have to take the RMD no matter which option you choose.

If you inherit a 401k from someone other than your spouse, you can still take a lump-sum distribution, but this may push you into a higher bracket and raise your income tax. As an alternative, you can leave the 401k as is and take distributions over time, whenever you want, and in any amount you want, as long as you withdraw all the funds from the account by the end of the 10th calendar year after the original owner’s death. You could also transfer the assets from the 401k into an inherited IRA, but again, you would need to empty the account balance by the end of 10 years.

If the person you inherited the 401k from was older than 72 and already taking RMDs as part of their retirement plan, you must continue taking them. Although, you can take out more than required and space the distributions over the deceased’s life expectancy or your own, whichever is longer.

There is another option that will allow you to completely avoid paying taxes on a 401k inheritance: disclaim it. If you disclaim a 401k inheritance, it will go to the contingent beneficiary, and you will have no tax issues to deal with. You could consider this option if you don’t have a financial need for the distributions or would rather it go to someone else.

It’s always hard to lose a loved one, and making financial decisions during those times can be difficult. Deciding what to do with a 401k or other inherited investments can be a complex process that depends on many other factors, far beyond what can be covered here. That’s why it is important that you talk to your financial planner and tax specialist before you make any decisions.

Contact a financial advisor today to see which 401k inheritance option is right for you.