My wife inherited a 401(k)–what’s the best way to avoid a big tax hit?

by Eren Rosa
0 comment

Q.: My wife inherited a 401(k) from my mom who died recently. How do we handle this? If she takes her share out will it count as income for us on our taxes? I read that we can’t roll it over into our TSP account. I read on one of your articles about converting to an inherited Roth IRA. Which would be the correct way to handle it? Thanks.

A.: Sorry for your family’s loss. Assuming this is a traditional 401(k), you are correct that whatever comes out of the account will be likely be taxable to you. If the account holds any after-tax money, a portion of any distribution will not be taxable.

You are also correct that you cannot roll it into your TSP or any other non-inherited retirement plan. If you do not wish to take it all at once, you can take it out over time.  

If your mom was 72 or older, the first thing to check on is whether your mom took her annual Required Minimum Distribution from that account. If not, the RMD will need to be taken and is taxable to you as the beneficiary.

You have three basic options in the tax code. They are, in no particular order:

  1. Transfer your wife’s share of the money to an Inherited 401(k) with the company that held your mom’s 401(k). If done properly, there is no tax upon transfer, but withdrawals are taxable to the beneficiary in the year they are taken and cannot be rolled over into any IRA or retirement account. Each 401(k) can impose rules about how money is disbursed from the account. These rules do not always line up with beneficiary wishes. Further, plans can also be inflexible as to whom your wife’s choice of her successor beneficiary(ies) which would receive the funds should she pass away before taking it all out herself. You can find these rules in the Summary Plan Description documents the 401(k) administrator is obligated to give you.
  2. Transfer your wife’s share of the money to an Inherited IRA. If done properly, there is no tax upon transfer, but withdrawals are taxable to the beneficiary in the year they are taken and cannot be rolled over into any IRA or retirement account. This option typically provides more investment options, may offer more flexibility about when to take withdrawals, and may allow your wife more choices for whom she names to receive the funds should she pass away before taking it all out herself than a 401(k) will allow for Inherited accounts.
  3. Convert your wife’s share of the money to an Inherited Roth IRA. This would not be an option if the account were an IRA. Taxes are due on all converted amounts for the year of transfer but if done properly, subsequent withdrawals are not taxable to the beneficiary in the year they are taken. Distributions from an Inherited Roth IRA also cannot be rolled over into any other type of IRA or retirement account. This option typically provides more investment options, may offer more flexibility about when to take withdrawals, and may allow your wife more choices for whom she names to receive the funds should she pass away before taking it all out herself. Converting is wise if the taxes paid upon conversion would be lower than taxes paid if taken out later.

Regardless of which option she chooses, unless she qualifies as an “Eligible Designated Beneficiary,” she must empty the account by the end of the 10th year after the year of the original owner’s passing. Due to IRS proposed rules it is unclear if any distributions would be required before that 10th year.

I can’t touch on all nuances here, so please work with your adviser to dig into the details applicable to you.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

Related Posts