4 Important Things To Know About Inherited 401 (k) s – The Motley Fool

If you just inherit a 401 (k) from a deceased parent, you may not know how to proceed. You may be able to leave money where it is, but it is not always a smart decision.

Even worse: if you do not understand how the money will be taxed, you risk losing more of your legacy to the government than necessary. Here are four things to know about the 401 (k) s inherited if you are the designated beneficiary.

1. How beneficiaries are chosen

Under the law, your spouse is designated as your 401 (k) beneficiary unless he / she is already deceased or signs a waiver waiving his / her right to money. Then you can leave the money to another family member, friend or group of your choice. It is important to keep your beneficiaries up to date because if no surviving beneficiary is listed at your death, the money will instead go to your estate, which may limit the way your heirs can receive distributions. For example, the plan may require the heirs of the estate to withdraw the money in a lump sum, which forces them to pay tax on the full amount in a single year, whether they want it or not.

2. Spouses can transfer funds to their own accounts

Surviving spouses have the same distribution options as beneficiaries other than spouses (see below), but they also have the option to transfer the funds into their own IRAs. The main reason people choose to do this is that they can delay the minimum required distributions (RMD). These are mandatory withdrawals from all retirement accounts, with the exception of the Roth IRAs, which the government requires people aged 70 and over to take in order to ensure the reduction of its tax. You can withdraw more than this amount per year if you wish, but if you withdraw less, you will have to pay a 50% penalty on the amount you should have withdrawn. RMDs are determined by the account value and age of the account holder.

If you do not transfer the 401 (k) to an IRA in your own name, you will need to start taking DMRs when your spouse will have reached the age of 70 1/2, or if he / she had already 70 and over or more. you will have to continue taking distributions based on the age your spouse would have been that year. You can determine how much you need to withdraw using this table. Simply divide the total value of the account by the distribution period corresponding to the age that your spouse would have today if he was still alive.

The problem with this approach is that DAMs may require you to withdraw more money than you want, perhaps pushing you into a higher tax bracket, where you will lose more of your legacy to the government. Although you can not postpone RMDs indefinitely, you can delay them by transferring 401 (k) money from your deceased wife to an IRA in your own name. Then you will not have to take any DMA until you reach 70 1/2. In addition, you will not pay any tax on the money until you withdraw it when you retire. Of course, if your deceased wife was younger than you, it might be best not to go to step 401 (k), because you will then be able to defer the DMR until your wife has reaches the age of 70 years and a half.

The disadvantage of substituting an IRA 401 (k) inherited at an IRA is that, if you are under 59 1/2, you can not touch the money once you canceled it without incurring an early withdrawal penalty of 10%. unless it is for a qualified reason. So, if you need money now, you'd better use one of the methods below.

3. You can transfer money into an inherited IRA

The most popular option for non-spouse beneficiaries is to transfer money into an inherited IRA. If there are multiple beneficiaries, each can have his own inherited IRA with a share of the money. This is a new account created in your own name, allowing you to designate your own beneficiaries. Unlike traditional IRAs, you can still receive distributions from this account when you are under 59 1/2 without incurring a 10% early withdrawal penalty. But you still have to pay income tax unless it comes from a Roth 401 (k).

You can use your distributions in one of three ways: remove it in one go, split withdrawals over five years, or use RMDs based on your own life expectancy. This last option is the most popular because it allows you to spread taxes over several years instead of paying in one year. Plus, this allows the money to stay longer in the IRA and continue to grow.

Your RMD for a legacy IRA or 401 (k) is based on the IRS 'unique life expectancy table. You look at your age and the life expectancy factor associated with it. Then you divide the total value of the account by that number. So if you are 35 years old and the account you inherit is worth $ 100,000, you will find that the life expectancy factor at age 35 is 48.5. So you would divide $ 100,000 by 48.5 and you would get $ 2,061.86. This is the minimum amount you would have to withdraw this year to avoid penalties. Next year you would do the same thing, but this time with the life expectancy factor at 36 years old.

4. You may be able to leave money where it is

Although the best thing to do when you inherit a 401 (k) is to leave it where it is, it's rarely the smartest decision.

On the one hand, if you leave the 401 (k) where it is located, you will need to take RMD based on the life expectancy of the original owner if you do not remove the 401 (k) from where it is located, you will have to take RMD based on the life expectancy of the original owner if you do not remove it. money in one go or in five years. You also can not choose your own beneficiaries for money when you leave it. If you were to die unexpectedly, this money would go to your estate.

It should also be noted that under the 401 (k) plan, you may not be allowed to leave the money where it is. The employer of the deceased will also have a say on how the money is processed. Some may require that the money be distributed as a lump sum or at the end of the fifth year following the death of the employee. Examine the rules relating to the deceased's 401 (k) plan to see if there are any restrictions on how you can collect the distributions before deciding on a withdrawal strategy.

Whichever choice you make to manage your 401 (k) legacy, it is important to understand the tax implications of your decision in order to avoid any unpleasant surprises at the time of tax.