401(k)s and estates: What you need to know

Think about taxes—when they’re paid and by whom—when deciding who inherits your 401(k).

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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, two 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.

By law, a spouse must be the beneficiary of a 401(k) unless he or she signs 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 five 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. Some governmental retirement plans, church plans, and 403(b) plans may be subject to state laws regarding beneficiaries. Your plan’s restrictions may have significant tax consequences, so be sure to check with the plan administrator to get your plan’s rules. 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 2016, it is $5.45 million (effectively $10.9 million for married couples). The annual federal gift tax exclusion amount is $14,000 for 2016. Many states also have estate or inheritance taxes, and the exemption amounts vary.

But the tax that’s far more likely to affect people who inherit a traditional 401(k) plan is federal and state income tax. (Roth 401[k]s are not subject to income taxes because all contributions are made with money that has already been subject to 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.

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). 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, the surviving spouse can either leave the money with the 401(k) provider or roll it over to his or her own IRA. (Leaving an inherited 401(k) with the provider generally means you are subject to plan rules.) For a surviving spouse under age 70½, he or she would not have to take required minimum distributions (RMDs) on the inherited 401(k)—whether it remains in the plan or is rolled over to an IRA—until age 70½. If the surviving spouse is over age 70½, he or she would have to take RMDs whether it is left in the 401(k) or is rolled over to an IRA. 

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 in to 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 five years. Check with your plan provider.) If the nonspouse beneficiary directly rolls over inherited 401(k) assets to an inherited IRA, he or she can generally calculate the RMD based on his or her 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 married filing jointly and she had a taxable income of $70,000 before the 401(k) distribution, the extra $100,000 in taxable income would move her from the 15% tax bracket all the way into the 28% tax bracket. Thus, she would pay income tax at a much higher rate if she distributed the 401(k) in a lump sum.

However, if she rolled it over to an inherited IRA, 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 would be no income tax consequences. 

Now that we’ve covered the basics, here are three things to consider now.

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 adviser or accountant for help on how NUA may apply in your situation. For more information, read Viewpoints: 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, either as alternates on the original document you filed with the plan administrator or as the primary ones on an amended form. This is vital, because the plan 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, and may be subject to rules that require the balance be taken as a lump sum or fully withdrawn within five 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. You may also want to consider leaving retirement plan assets to heirs with lower incomes—and therefore in lower tax brackets.

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.

In conclusion

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 adviser.

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This information is intended to be educational and is not tailored to the investment needs of any specific investor.

The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

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