Updated on July 28, 2024
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Saving for retirement is a crucial part of anyone’s life, but what happens to those retirement savings when a plan participant passes away?
401(k) retirement accounts don’t disappear if an accountholder were to pass away. Instead, your 401(k) retirement funds, like most other property, typically passes to a loved one; this could be a spouse, child, or other designated beneficiary.
Surprisingly, many people may not realize they are named beneficiaries on a 401(k) — and, consequently, might suddenly find themselves with an unexpected lump sum of money.
In this article, let’s take a look at everything you need to know about what happens to your retirement investments upon death, including beneficiaries, distribution options, and more.
We’ll also explore how those who are inheriting a 401(k) can navigate this process while ensuring the accountholder’s hard-earned savings are handled as they intended.
Federal law dictates that upon the owner’s death, a 401(k) generally transfers to its designated beneficiaries (or those who “benefit” from the account’s contents). However, the process isn’t always straightforward and can sometimes result in an unexpected tax burden for the recipient (or recipients, if there are multiple beneficiaries).
Planning ahead is critical for the current 401(k) accountholder. This means taking the time to actually name beneficiaries, which involves contacting your plan administrator and filling out a beneficiary update form.
Setting out your intentions for your retirement account and sharing your estate plan with your beneficiaries can ease the process in the event of your death. For those left behind, understanding what to expect can help prepare for decisions about the inherited funds, and, importantly, can provide valuable peace of mind.
Do you have an old 401(k) you’re no longer contributing to? Capitalize can help you roll it into an Individual Retirement Account (IRA).
Take a look at some common options for 401(k) owners.
If you are a surviving spouse, you are likely to be a primary beneficiary of your late spouse’s 401(k). You will have various options as it relates to the 401(k)’s distribution.
One such option is to merge it with your own retirement plan. Here, when you need to start taking Required Minimum Distributions (RMDs) will depend on whether or not your spouse had passed his Required Beginning Date (RBD), which is currently age 73.
Note that RMDs are taxed as ordinary income, and they can get expensive in retirement — especially if you’re now filing taxes as a single person as opposed to a married person filing a joint tax return.
Another option is to roll over the deceased’s 401(k) account into a newly-created inherited IRA, which will then need to be depleted according to the life expectancy method. In other words, if your spouse had passed their RBD, then RMDs will be due every year according to your life expectancy. If they hadn’t yet reached their RBD, then you can postpone taking RMDs until the year in which the decedent would have turned 73.
A 401(k) to IRA rollover, even after death, can make financial sense, especially if it allows pre-tax savings to remain tax-deferred in a traditional IRA until you decide (or are forced) to take a payout and pay taxes. If the decedent had an after-tax Roth 401(k), you’d want to move that account into an inherited Roth IRA to maintain the same tax treatment.
A third option is to elect the ten-year rule, and deplete your spouse’s entire 401(k) over a ten-year period beginning with the year after their death. This is only an option for the surviving spouse if the original account owner had not yet reached their RBD.
Finally, as the surviving spouse, you have the option of taking a lump-sum distribution of your spouse’s retirement fund. This is often a dicey choice since you’ll owe income taxes on the entire amount distributed, though you will receive a waiver for the infamous 10% penalty. You may also get bumped into a higher tax bracket depending on your other income as well as how large your spouse’s 401(k) is.
You might also choose to disclaim the inherited 401k plan and pass it to another named beneficiary, like a minor child or alternative contingent beneficiary. But this might only happen in select circumstances.
Because this is an exceedingly complex topic, it’s essential to understand how your beneficiary designations will play out in practice, and that you fill out beneficiary forms with the utmost care. You may want to start by brushing up on the main differences between a 401(k) and IRA.
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It’s also possible to inherit a 401(k) account from someone you’re not married to — a parent, friend, or legal guardian. Different rules apply in these situations. The major difference in options for non-spouse beneficiaries (relative to spousal beneficiaries) is that they’re not allowed to roll over the left-behind 401(k) into their own accounts.
However, they do have a few options, depending on your relationship to the decedent. Primarily, it matters whether you’re an eligible designated beneficiary or not.
You’re an eligible designated beneficiary if:
If this is you, when you’re required to withdraw money depends on whether or not the original account holder reached their Required Beginning Date. If they didn’t reach their RBD yet, you can roll the funds to an inherited IRA and elect the life-expectancy method, elect the ten-year rule, or take a lump sum distribution.
If the original account holder already reached their RBD before death and was taking RMDs, you can either elect the life-expectancy method or take a lump sum distribution.
If you are not an eligible designated beneficiary, the rules are a bit simpler. You must deplete the entire 401(k) account by the end of the 10th year following the account owner’s death, which could lead to significant tax implications in the years during which distributions are received. If the decedent had already passed their RBD, you’ll also be responsible for taking Required Minimum Distributions along the way to depletion.
As mentioned, each annual distribution is added to the beneficiary’s taxable income for the year, which will have varying consequences depending on the total circumstances of the person that receives it.
Finally, the beneficiary has the option to disclaim the account, effectively rejecting the inheritance. Disclaiming the account can be beneficial for various reasons, such as reducing estate tax or passing the retirement funds onto other beneficiaries who might be in a lower tax bracket.
No matter how you look at it, it’s a complex process, and it’s recommended to consult with a qualified and knowledgeable financial advisor to understand all the implications.
When you inherit a 401(k), you have a variety of options available to you. From becoming the new account owner to rolling it over into your own IRA, or even disclaiming the account entirely, it’s crucial to understand the implications of each choice. Remember that the rules can change based on your relationship to the original account owner, your age, and whether the decedent had hit their Required Beginning Date (RBD) Yet.
To ensure you’re making the right decisions, consider speaking with a financial advisor or professional service provider, like a reputable financial institution. They can guide you through the process of making retirement plans after a loved one’s death and managing an inherited 401(k).
If you are a surviving spouse that recently inherited a 401(k), Capitalize can help you easily roll it over into an IRA of your choice.
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