You worked hard all your life, contributed regularly to your 401(k), and built a healthy balance. You may want to leave some of that money to your heirs. Of course, the last thing you want is for a big chunk to be taken out for taxes, or for your heirs to be left with a tax burden. In fact, 2 of the biggest tax considerations affecting how your 401(k) account will be distributed after you die are when the income tax is paid and by whom.
"After deciding who you want to inherit the money, the main objective is to reduce the tax bill," says Rodney Weaver, estate planning specialist for Fidelity Wealth Planning and Personal Trust. "Smart handling of 401(k) accounts can provide additional flexibility and leave your heirs a long-term, tax-advantaged investment account."
Note: For simplicity, this article will refer to 401(k)s, but unless otherwise noted, the information applies to 403(b) and governmental 457 plans as well.
Inheritance rules for 401(k)s—the basics
Who inherits the money in your Roth or traditional 401(k) plan when you die is determined by the beneficiaries you name for the plan—not by your will. That may come as a surprise to many people.
Typically, a spouse must be the beneficiary of a 401(k) unless they sign a waiver. If your spouse does, you can then designate anyone you wish to receive the money—children, friends, a trust, or a charity.
In general, money from an inherited 401(k) can be distributed in a number of ways, including a lump sum, over 5 years, or, potentially, stretched out over many years based on the beneficiary’s life expectancy. It is important to consult with a tax professional before making a decision.
Another fact that surprises many people is that some workplace savings plans impose more restrictions than others. Some may require heirs to take the money all at once or limit how the money is handled. Smaller payments stretched out over many years are generally better from a tax and investment growth standpoint, says Weaver.
Taxes and 401(k)s
Your 401(k) plan, whether Roth or traditional, could be subject to federal estate tax if your estate’s value—including nonretirement accounts, business interests, personal property, and more—exceeds the federal lifetime gift and estate tax exclusion amount. For 2019, it is $11.4 million (effectively $22.8 million for married couples). The annual federal gift tax exclusion amount is $15,000 for 2019. Many states also have estate or inheritance taxes, and the exemption amounts vary.
But the taxes that are far more likely to affect people who inherit a traditional 401(k) plan are federal and state income tax. That’s because in most cases income taxes have been deferred on retirement plan contributions and earnings. That’s one of the main benefits of participating in a traditional 401(k) plan in the first place. (Roth 401(k) contributions are not subject to income taxes because all contributions are made with money that has already been subject to income tax.)
The tax deferral on money in a traditional 401(k) doesn’t last forever. You will generally have to pay income tax on your plan assets when you withdraw them from the tax-deferred account (except for after-tax contributions and Roth 401(k) contributions). Your heirs will have to do the same when taking distributions from a traditional 401(k) plan you leave to them.
When someone inherits your 401(k)
If the inheritor of a Roth or traditional 401(k) is a spouse or the employee, the surviving spouse can either leave the money in the 401(k), roll it over to their employer-sponsored plan (assuming the plan permits rollovers) or roll it to their own IRA, or to an inherited IRA. Leaving an inherited 401(k) with the provider generally means you are subject to plan rules.
One factor to consider when determining when to take the required minimum distributions (RMDs) is whether the deceased spouse had commenced RMDs. If the deceased spouse had not commenced RMDs, then a surviving spouse would not have to take RMDs on a 401(k) until the year the participant would have attained age 70½. If the surviving spouse leaves the funds in the plan, they'd need to commence RMDs in the year the deceased spouse would have attained age 70-1/2. If the beneficiary rolls the account over to their own IRA, then RMDs from the IRA begin during the year that they themselves turn 70-1/2.
Nonspouse heirs can also either leave a Roth or traditional 401(k) plan with the plan provider (if the plan allows) or directly roll it into an inherited IRA. If the original account owner was under age 70½, the RMDs will be based on the inheritor's age—this is the "stretch out". (Important note: Not all plans allow a beneficiary to stretch out RMDs. Some may require the money be removed from the plan in a lump sum or within 5 years. Check with your plan provider.) If the nonspouse beneficiary directly rolls over inherited 401(k) assets to an inherited IRA, they can generally calculate the RMD based on their life expectancy. The longer the beneficiary’s life expectancy, the greater the tax-deferred earnings potential of the inherited traditional IRA, or tax-free earnings potential in the case of an inherited Roth IRA.
Suppose, for example, that a 69-year-old father leaves a traditional 401(k) account valued at $100,000 to his 45-year-old daughter. If the daughter were to take the money in a lump-sum distribution, she would owe income tax on all of it in the current year, and that could push her into a higher tax bracket. If the daughter filed her taxes as single and she had a taxable income of $70,000 before the 401(k) distribution, a portion of the extra $100,000 in taxable income would be applied to a higher tax bracket (32% marginal rate vs 22%). Thus, she would pay income tax at a much higher rate if she distributed the 401(k) in a lump sum.
However, if she requests a direct rollover to an inherited IRA or leaves it in the 401(k) plan, she would have to take an RMD each year. Based on the IRS’s "single life expectancy" table, she could stretch out her RMDs over as many as 38 years if she took the minimum withdrawal each year. Her RMDs are still taxable income each year, but her tax liability will be stretched out too. Note: If the 401(k) in this example was a Roth 401(k), the RMD requirement would still apply; the only difference is that there may be a reduced income tax liability (amounts attributable to original Roth contributions are not subject to income tax).
We've covered the basics, so here are 3 possible actions to consider.
1. What to do now: Consider a rollover
If you’re already retired or have assets in a former employer’s 401(k), you might want to consider rolling the account to an IRA. A rollover IRA (assuming certain IRS requirements are met) may give your heirs more flexibility. However, this is an important decision, so you need to weigh the costs and benefits of doing a rollover vs. keeping the money with your 401(k) provider.
One situation in which rolling over 401(k) assets to an IRA might not be in your (or in your heirs’) best interests is when a large portion of the account is in your employer’s company stock. If you own appreciated company stock in your workplace savings account, consider the potential impact of net unrealized appreciation (NUA) before choosing a rollover. Special tax treatment may apply to appreciated company stock if you move the stock from your workplace savings account into a regular (taxable) brokerage account rather than rolling the stock (or its proceeds) over to an IRA. You may want to consider asking a financial advisor or accountant for help on how NUA may apply in your situation. For more information, read Viewpoints on Fidelity.com: Make the most of company stock.
2. What to do now: Carefully choose beneficiaries
Many married 401(k) plan participants do name their spouses as the primary beneficiary on their account. If your spouse is deceased or you’re single, however, it’s important to make sure you have named other beneficiaries. This is vital, because if the plan does not include beneficiaries, the administrator will not automatically pass the assets to your children or other close family members if they are not specifically designated. Instead, the assets would go directly into your estate. Then your assets may be subject to rules that require the balance be taken as a lump sum or fully withdrawn within 5 years, cutting short the potential stretch benefits. Even if your spouse is your primary beneficiary, it’s a good idea to make sure you’ve named contingent beneficiaries. Your spouse might pass away before you, and you might not remember or have time to deal with changing your plan beneficiaries at that point.
Another important consideration is the age and income tax bracket of your beneficiaries. If your spouse doesn’t need the 401(k) assets, you may want to leave the money to your children or grandchildren. Younger heirs typically would be able to benefit the most from an extended distribution or stretch period, as previously described.
3. What to do now: Consider a trust
If maintaining greater control over your 401(k) assets after you die is important to you—perhaps to protect your heirs from creditors or to provide financial oversight for a young child or grandchild—consider naming a trust as the beneficiary of your retirement plan assets. (If you are married, you may need to have your spouse sign a waiver.) Make sure you work with an estate planning attorney if establishing a trust.
For enhanced tax efficiency, the entity must be set up as a "see-through" or "look-through" trust; that is, the beneficiaries of the trust must be properly identified. If you name multiple trust beneficiaries (children or other family members, or friends), the age of the oldest beneficiary may be used to calculate the RMD schedule. If there’s a significant age difference between the beneficiaries, you might want to consider providing for multiple trusts, one for each child, and dividing the retirement plan assets among the separate trusts.
Naming a beneficiary isn’t the only consideration when deciding what to do with your 401(k) assets when you pass away. The many rules surrounding workplace savings plans, RMDs, rollover and inherited IRAs, and see-through trusts can be complicated. It is a good idea to consult with a financial or tax advisor.
Next steps to consider
A rollover IRA (assuming certain IRS requirements are met) may give your heirs more flexibility.
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