Avoid Making Costly Moves With A Non-Spouse Inherited 401(k)

A non-spouse inherited 401(k) has limited options compared to that of a spouse. If you are guiding minor children, there are some unique twists. These rules require careful navigation. I tackled the spousal options in “Contemplating Your Spousal Inherited 401(k) Options”. The SECURE Act 2.0 has changed how non-spouse beneficiaries handle inherited 401(k)s, especially when it comes to required minimum distributions (RMDs).

Unlike a surviving spouse, you cannot roll over an inherited 401(k) into your own retirement account. However, you have several options for managing the account, depending on your financial needs, age, and the deceased’s circumstances. Here’s what you need to know to make the most of your inheritance while avoiding costly mistakes.

The SECURE Act’s 10-Year Rule

The SECURE Act 2.0 fundamentally changed the distribution timeline for non-spouse beneficiaries. Previously, you could stretch withdrawals over your life expectancy, but now, most beneficiaries must empty the account within 10 years.

If the account holder died before starting RMDs:

• You can withdraw funds at any time within the 10-year period, with no specific schedule required.

If the account holder died after starting RMDs:

• Annual RMDs must continue during the first nine years, with the full balance withdrawn by the end of year 10.

Understanding whether the account holder had begun taking RMDs is critical in determining your withdrawal strategy. The penalty for missing a Required Minimum Distribution (RMD) is a 25% excise tax on the amount you failed to withdraw, meaning the IRS will charge you 25 cents for every dollar you didn’t take out on time; however, if you “timely correct” the mistake within two years, the penalty drops to 10% of the missed RMD amount.

For more details, visit this guide from IRS.gov.

Key non-spouse inherited 401(k) options

When inheriting a 401(k) as a non-spouse, you have the following options:

1. Take a Lump-Sum Distribution

This option allows you to withdraw the entire account balance in one go.

Pros:

• Provides immediate access to funds.
• No 10% early withdrawal penalty, regardless of your age.

Cons:

• The full amount is taxed as ordinary income in the year of withdrawal, potentially pushing you into a higher tax bracket.
• Misses out on future tax-deferred growth.

Any withdrawals are added to your current year taxable income. Current federal and state taxes could cut the net proceeds over 40% depending on federal and state taxes depending on your income.

2. Transfer the Funds into an Inherited IRA

A popular option is to transfer the inherited 401(k) into an inherited IRA. The account remains in the name of the deceased but is managed for your benefit.

Pros:

• Offers flexibility in taking distributions.
• Funds can continue to grow tax-deferred.

Cons:

• The 10-year rule still applies. You must withdraw the full balance within 10 years.

Tax Implications for non-spouse inherited 401(k)

Distributions from an inherited 401(k) are taxed as ordinary income. As a non-spouse beneficiary, managing your withdrawals to minimize taxes is essential. Consider the following strategies:

• Know your current marginal tax bracket.
• Evaluate your current and future income to determine the most tax-efficient years to take larger distributions. Will you be in a higher or lower tax bracket?
• Spread withdrawals across the 10 years to avoid being pushed into a higher tax bracket. It may not mean much if you are pushed into the 24% bracket from 22%. However, being pushed into the 37% bracket means losing tens of thousands of dollars intended for you to the IRS.

Special Considerations for Eligible Designated Beneficiaries

Certain non-spouse beneficiaries qualify as “eligible designated beneficiaries” under the SECURE Act. These include:

• Minor children of the account holder (until they reach the age of majority).
• Disabled or chronically ill individuals.
• Beneficiaries less than 10 years younger than the deceased.

Eligible beneficiaries may have the option to take distributions over their life expectancy, rather than being subject to the 10-year rule. However, once a minor child reaches adulthood, they must follow the 10-year rule.

For more information, visit this SECURE Act overview.

Steps to Take with a non-spouse inherited 401(k)

1. Contact the Plan Administrator

Notify the 401(k) plan administrator of the account holder’s death. They will provide details on the account balance, available options, and deadlines.

2. Understand Deadlines

The clock starts ticking on January 1 of the year following the account holder’s death. Missing deadlines can result in penalties, so familiarize yourself with the 10-year rule.

3. Decide How to Manage the Account

Evaluate your financial goals and tax situation to decide whether to take a lump-sum distribution or transfer the funds into an inherited IRA.

4. Consult a Certified Financial Planner or other retirement designated professional

Inherited retirement accounts are subject to complex rules. A Certified Financial Planner or other retirement designated professional can help you navigate your options and make decisions that align with your overall financial plan.

Common Mistakes to Avoid

1. Ignoring the 10-Year Rule

Failing to withdraw the full balance within 10 years can result in a 25% penalty on the remaining amount.

2. Taking Large Distributions Without Planning

A significant lump-sum withdrawal can create a hefty tax bill. Spreading withdrawals over several years can help manage taxable income.

3. Not Understanding Potential RMD Requirements

If the account holder had started RMDs, you must continue taking them during the 10-year period. Missing these annual withdrawals can result in penalties.

Conclusion

A non-spouse inherited 401(k) can provide significant financial benefits, but it also comes with responsibilities. Managing an inherited 401(k) as a non-spouse beneficiary requires careful planning. The 10-year rule means you need to act quickly to develop a strategy that minimizes taxes and maximizes the account’s potential.

Whether you choose a lump sum or an inherited IRA, understanding your options is crucial to avoid penalties and make the most of this financial opportunity.

For additional resources, see this IRS guide on inherited retirement accounts.