What to Do When Inheriting a 401k
There may come a time when you are the benefactor of an inheritance. The circumstances of receiving an inheritance are certainly bittersweet. Loss is always challenging. The natural question that follows is what to do when inheriting a 401k or IRA from your parents or someone else.
The wealth accumulation of the baby boomer generation, and the generation before, has really compounded over the past 50 to 60 years. This means the amount of money you may receive from an inherited 401k or IRA can be significant. There are sometimes challenges and headaches along with the situation.
Paperwork surrounding an inherited 401k is not always straightforward. This adds another level of stress or difficulty during the process. Here are a few things you can do when inheriting a 401k to make the process easier.
Assess Your Situation
The first thing is assessing your situation. In particular, what your income level is. If you’re married, look at the combined total of your and your spouse’s income. What does your income look like relative to your tax bracket?
When you inherit a 401k or IRA, there are potential tax ramifications associated with it. Understanding your tax situation is imperative to decide how and when to take the money. Consider how receiving the inheritance may affect your tax situation. This knowledge will help guide you on what to do with the money you are receiving.
Do You Need the Money Now?
Are you in a situation where you need the money right away? There are several reasons why you may need the money right away.
- To pay off debt
- College tuition for your children
- Buy a vacation property
You are inheriting your parents’ money when you inherit a 401k or IRA. What was their money is now yours. You can decide if you want to use the money now or not. If you do, what does that look like? Whatever the reason, it should be factored into your decision.
Understand the Tax Ramifications
Many people who inherit a 401k or IRA do not fully understand the tax obligations attached to it.
Inheriting a 401k or IRA
When you inherit a traditional contribution 401k, your parents didn’t pay taxes on the money they put into it. If they were older than 73, or in some cases 70 ½, they were forced to take the required minimum distribution from the 401k.
The primary thing to know is that, for a traditional 401k inheritance, all the money that now comes to you is taxable. If it’s $500,000 in a traditional 401k or traditional IRA, that is potentially $500,000 of taxable income coming to you.
Understanding how the taxes work is vital when making decisions and what to do when inheriting a 401k or IRA. You don’t want to be caught off guard or incur a substantial tax obligation.
Inheriting a Roth
The tax obligations are different if you are inheriting a Roth contribution instead. Roth contributions are not taxable because your parents paid the taxes when the contributions were made. They may have paid the taxes during contribution or by completing a Roth conversion. Regardless, the money coming to you will be tax-free because your parents paid the tax already.
Be sure you understand the source of your inheritance. If you aren’t sure, ask. Were the funds accumulated through
- Traditional contributions
- Roth contributions
- A combination of both
I’ve discussed the relationship between taxes and various retirement account types before, so I won’t go into specifics here. Remember, Roth money is tax-free. Traditional funds will be taxed at the federal level. If you have inherited a retirement savings account or may in the future, it’s worth a few moments to read the previous article for a deeper look.
Know the Timing
The timing of receiving the money is an essential factor, especially with the Secure Act. You should know that when you inherit a 401k or IRA, you can roll that into what’s known as an inherited IRA. Congress has just changed the rules on inherited IRAs. Let’s take a look.
Pre-Secure Act
Pre-Secure Act, you could do what’s called a “stretch IRA.” You were allowed to receive the funds into an inherited IRA. You would then be required to take distributions based on either your or your deceased parent’s lifetime. Some qualifications would determine the distribution, including if your parent was at the age of required minimum distribution.
If you’ve inherited a pre-Secure Act IRA, you’re still under the old rules. You may be required to take the distributions forever until the money runs out.
Post-Secure Act (and Secure Act 2.0)
After Congress passed the Secure Act and now Secure Act 2.0, the money has to be taken out within a 10-year period. There are required minimum distributions, and you must drain the entire account after ten years.
Let’s say you received a $500,000 401k inheritance from your parents. The entire account will need to be drained over those ten years. At the same time, you will have to take minimum distributions along the way. Those distributions are calculated using various factors, including the value at the end of the previous year and your age.
The difference is that the distributions and money may be taxable with traditional accounts. You will still have mandatory distributions with a Roth, but the money is tax-free, which is a nice benefit.
Consult with a Professional
As a side note, there are special rules when you inherit a 401k or IRA from your spouse. Some things we’ve discussed today do not apply in those instances. In any case, when you inherit a 401k or IRA, you should talk with your financial planner, attorney, and tax advisor before making decisions.
If you want help from an experienced financial planner to understand your inheritance and what to do with it, I’m happy to speak with you.
We can meet virtually or in person if you live in the Central Florida area. Please email me at kyle.newell@newellwm.com, call/text at 407.337.7128, or schedule a meeting at Schedule – Newell Wealth Management (newellwm.com)
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