Talk about good news wrapped in bad: In the midst of grieving the loss of a loved one, you learn that you were named beneficiary of their 401(k) plan. Chances are you’ve got too much on your mind to make any sudden decisions about what to do with the money.
However, don’t procrastinate too long. The IRS has ironclad rules, deadlines and penalties concerning inherited retirement accounts, which vary depending on what type of account it is.
Under federal law, surviving spouses automatically inherit their spouse’s 401(k) plan unless someone else was named beneficiary and the surviving spouse signed a written waiver. If someone is single at death, their plan’s assets go to their designated beneficiary.
The IRS has basic tax and distribution rules and timetables for inherited 401(k) plans. However, the plans themselves are allowed to set more restrictive guidelines if they choose, so read the plan documents carefully.
You must pay income tax on distributions (except for Roth accounts, which have already been taxed), although you may be able to spread out withdrawals and tax payments over a number of years, depending on how you structure it.
Many 401(k) plans require beneficiaries to withdraw the money in either a lump sum or separate payments extending no longer than five years after the person’s death; however, some will allow you to keep the money in the plan indefinitely, so check their rules.
Note that distributions will be added to your taxable income for the year, which can greatly increase your tax bite. Thus, many people prefer to spread the payments out as long as possible. Plus, the longer funds remain in the account, the longer they accrue earnings, tax-free.
If the original account holder had already reached the mandatory withdrawal age of 70