When someone passes away, their 401(k) becomes part of their estate, meaning that the appropriate beneficiaries can inherit it in a process that is subject to Federal estate tax. The procedure often takes several months—even up to a year—but once it is complete, you can receive your inheritance funds.

A major challenge is that although inheriting a 401(k) can be exciting, there are some important steps to take to properly manage your new asset. With careful management, an inherited 401(k) can become an extremely rewarding asset for years to come.

In this guide, we explain what to do if you inherit a 401(k) and how you can make the best out of it.

What is an Inherited 401(K)?

A 401(k) scheme is an employer-sponsored retirement plan that allows people to set aside money for their future. It is an integral part of financial planning and can be used to build wealth over time. An inherited 401(K) might come from a variety of sources. For example, you can get it from a spouse once they pass away.

Before you can start spending your 401(k), you’ll want to find out if there are penalties associated with rolling over funds into another account or withdrawing them prematurely, as we explain in the next section.

Assessing Your Options

Once you’ve inherited a 401(k), there are several decisions you need to make to determine the best course of action for your new account:

1. First, you should review the plan documents and contact the financial institution holding the funds. This move enables you to consider the nature of the account, associated fees, taxes, or penalties.
2. Next, take stock of the investment strategy currently being used by the previous owner. It’s essential to evaluate each asset class held within this account and decide if they match up with your retirement goals and objectives.
3. Now is an excellent time to assess whether this account should remain invested as-is or if you should add some changes through rebalancing or shifting some assets into different classes.
4. Finally, weigh the pros and cons of taking periodic distributions versus a lump sum distribution from the account.

Note: You can inherit a 401(k) as a spousal or a non-spousal beneficiary.

The following are your options for both instances.

Inheriting a 401(K) As a Spousal Beneficiary

As a spousal beneficiary, you can:

• Take a lump sum distribution: Use this option only if you need immediate access to the total value of the account.
• Transfer the inherited 401(k) into your personal 401(k) or IRA account: Rollovers don’t incur penalties, but converting to a Roth 401(k) may result in taxes.
• Move the funds from the 401(k) account directly to a new inherited IRA: This plan operates according to distribution rules for inherited IRAs.
• Keep the inherited 401(k) in its current plan: This option minimizes taxes because you withdraw money over time.

Inheriting a 401(K) As a Non-spousal Beneficiary

As a non-spousal beneficiary, you can:

• Move the funds directly from the 401(k) account to an inherited IRA: Roth 401(k) withdrawals or conversions to a Roth IRA have no tax implications, but converting a pre-tax 401(k) to a Roth IRA incurs taxes.
• Take a lump sum distribution: Provides immediate access to the money, but may result in high taxes if it raises your income or pushes you into a higher tax bracket.
• Keep the money in the 401(k) account and make withdrawals within 10 years: Requires withdrawing it within 10 years to comply with the 401(k)’s 10-year rule.

Conclusion

Knowing what to do with your funds once you inherit a 401(k) can be difficult. Nevertheless, with appropriate management and strategy, you can make sure that your inherited retirement savings are taken care of in the most efficient way.

The key is understanding what options are available to you and which best meets your needs. Whether it’s taking a lump sum distribution from the account, transferring the balance into an inherited IRA, or rolling it over into your own IRA, there’s no shortage of ways for you to maximize these assets.