If your loved one passes away and leaves behind a 401k retirement savings balance, and if you are the legal beneficiary of that 401k account, there are certain things you need to know in order to properly manage that money. This is known as 401k tax planning.
Treatment of 401k Inheritance for Taxes
Upon the death of a 401k retirement saver, all of his 401k savings and balances become taxable. You as the 401k beneficiary will immediately get access to the money and have to manage the taxes as well. There are certain taxes that you must pay, while there are some other taxes that you can easily dodge away, especially if you are the spouse of the deceased 401k saver.
Receiving Your 401k Inheritance
Each 401k plan has its own set of complex rules. For example, some 401k plans will allow you to store up your 401k inheritance treasure for years (without any withdrawals and any taxes being charged on them). However, other 401k plans will want you to withdraw this inheritance within a certain period of time, after which you may be assessed a penalty of 10% or more.
If you inherit someone else’s 401k, be sure to thoroughly read the Summary of the 401k Document and all its details to find out what tax rules apply to your instance of 401k inheritance. Usually, there are a special set of rules if the deceased 401k saver was your spouse and you are the beneficiary of your spouse’s 401k retirement savings.
Upon the death of a 401k saver, all his savings are inherited by the beneficiary in a lump-sum distribution (where all the money is at once handed over to the beneficiary, rather than monthly payments). Cindy McCabe, Senior Manager in Employee Benefits Tax Services at Deloitte and Touche (San Francisco) quotes, “Most plans will decide automatically to kick out the money. They do this for administrative reasons,” so they don’t have to use resources to keep track of the account of an employee who is no longer there.”
Upon receiving the lump sum distribution, you will be subject to local & federal state income taxes. However, you will NOT be assessed a 10% early withdrawal penalty for any early withdrawals.
Special Benefits of Spouse in 401k Inheritance
If you are a spouse and beneficiary of a 401k savings balance, you can perform an IRA rollover and defer paying taxes until the time you actually start withdrawing money from the plan. This can be accomplished by doing a direct IRA rollover whereby your spouse’s employer transfers the money directly to your IRA broker.
Note: Do NOT accept to receive the lump sum distribution to your checkings account. If you do, you must do an IRA Rollover within 60 days or face a 10% penalty fee as well as local and federal state taxes. Also, the employer will withhold 20% of your the lump sum distribution for the IRS taxes.
Characteristics of 401k Inheritance Distributions
– You can configure your 401k inheritance so as to receive example annual contributions spread out over a # of years, as opposed to a lump sum distribution.
– If the deceased 401k saver was receiving monthly or quarter or annual distributions from his account before his death, the same timing of payments and method can be used by the beneficiary of the 401k account.
– You can choose to receive larger distributions over a shorter period of time, but NOT smaller distributions over a longer period of time. Usually most 401k plans come with 3 types of payment schedules:
5 Year Payment Schedule
The 5 year payment schedule is when you receive the 401k balance over a period of 5 years.
Life Expectancy Payment Schedule
Life expectancy payment schedule is when you receive the 401k retirement savings over your life expectancy. The Uniform Lifetime table is used to calculate this payment schedule.