Do You Have to Pay Inheritance Tax on 401K?

Under certain conditions, a 401(k) will pass to heirs tax-free.
Under certain conditions, a 401(k) will pass to heirs tax-free. (Image: karamba70/iStock/Getty Images)

Federal tax law created the 401(k), a retirement account that can be funded by contributions from both employer and employee. In many ways, a 401(k) functions like an individual retirement account, but the employer and account manager can set more conditions on withdrawals. The IRS sets the rules on tax treatment when the funds in a 401(k) pass to a beneficiary.

Basic Rules on 401(k) Inheritance

When you sign up for a 401(k) account, you list a beneficiary: the person who will inherit the account when you die. In most cases the account will pass to the beneficiary outside of any probate court process. The plan itself may set the rules on when the plan assets can be withdrawn by the beneficiary, and govern the amount and frequency of these withdrawals. In some cases, the plan will require a lump-sum distribution to the beneficiary upon the death of the account holder.

Rolling Over a 401(k)

IRS rules allow a spouse who inherits a 401(k) to move the funds directly to her individual retirement account. In a direct rollover, the plan administrator makes the transfer. Alternatively, the administrator can distribute the funds to the beneficiary, but will have to withhold 20 percent of the amount against any tax liability. The beneficiary then has 60 days to send that money to another qualified account in order to avoid taxes on the 401(k) income.

Estate and Income Taxes

The IRS considers a "traditional" 401(k), which is funded with pre-tax money, to be part of the account-holder's estate, and thus subject to estate and income taxes in the same way that a bank or investment account would be. Under the Roth 401(k) rules, however, contributions are made with after-tax funds, and thus are not subject to income taxes when they're distributed. If the account holder died before he was required to start taking distributions, the beneficiary has to take distributions over a period of five years. If the plan was already paying out, then the beneficiary can hold to the same schedule or accelerate the payments, depending on what the plan allows. The IRS rules do not allow the beneficiary to spread payments out over a longer payout schedule.

Periodic Payments to a Beneficiary

If an inherited 401(k) was not already paying out, the beneficiary has a decision to make on how she receives payments. If the 401(k) plan allows it, a beneficiary can spread out payments, either over five years or over the years of her life expectancy -- as set in certain IRS tables -- to lessen the income tax liability. She has until December 31 of the year following the account-holder's death to make this decision. A spouse who doesn't make the decision in time is subject to the life-expectancy payout, while a non-spouse in the same situation would have to follow the five-year distribution rule. If the funds are rolled over into a new "inherited" IRA set up specifically to receive them, the life-expectancy schedule applies.

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