24 May Your 401K and Your Estate Plan

Choosing a beneficiary for your 401K is an important decision. Even though retirement accounts do not have to go through probate, they can still be subject to taxes and fees. And when it comes to inheriting a 401K account, different rules apply for charities, spouses, and non-spouse beneficiaries. 

In this guide, we answer the most frequently asked questions about inherited 401K accounts and how your 401K fits into estate planning.

What can you do with an inherited 401K?

Every 401K has required minimum distributions. After the owner of the account reaches the age of 73, they must begin taking distributions. If you inherit a 401K, you will have ten years to collect the funds, or else you could be charged some heavy penalties.

Non-spouse beneficiaries have three options:

• They can start receiving minimum distributions.
• They can take a lump sum distribution.
• They can open an inherited IRA account.

If you are the grantor’s spouse, you have the additional option of transferring the funds to your own 401K or IRA. If you are a non-spouse beneficiary, you have to empty the account within ten years of inheriting it. If the beneficiary is a minor, the ten-year limit begins as soon as they turn 21. However, there are exceptions to the ten year rule for beneficiaries that are disabled or chronically ill.

Does a 401K avoid probate?

Yes, retirement accounts are usually non-probate assets. Since the beneficiary designation on the 401K documents overrides any instructions in your will, the funds in your 401K will go directly to the person named. That means your beneficiary can cash out or start taking distributions right away—they won’t have to wait for court approval. 

Do beneficiaries pay taxes on an inherited 401K?

It depends on the type of 401K plan. A traditional 401K is funded with pre-tax dollars. If you inherit a traditional 401k, you will have to pay taxes when you take distributions. 

Withdrawals are taxed as income, so both federal and state taxes apply. The income tax rate will be based on your previous year’s income, not that of the 401K’s original owner. If you’re worried about taxes, be careful about taking a lump sum distribution. A large deposit could bump you up into a higher tax bracket.

Distributions from a Roth 401k, on the other hand, are tax-free, because the taxes were paid at the time of deposit.  

Are there any exceptions to taxes on a traditional 401K?

Charitable organizations are exempt from taxes on inherited 401K accounts. If you want the recipient of your 401K to get the most out of your savings, consider naming a nonprofit as the sole beneficiary of your account. Since retirement accounts are not subject to probate, your favorite charity will be able to start using your savings right away to fund their good work.

What about the 10% early withdrawal penalty?

There is a 10% early withdrawal fee if you take money out of your 401K before you’re 65.5 years old. However, the IRS waives this fee for inherited 401K accounts. 

Can you fund a trust with a 401K?

Typically, non-probate assets like your 401K do not belong in a trust. Yes, you can fund a trust with your retirement accounts, but it’s not always a good idea. There are strict laws about who can inherit a 401K, so naming your trust as beneficiary doesn’t always apply. Placing your 401K in a trust could also trigger early withdrawal fees, and the taxes could be due all at once.

On the other hand, if your beneficiaries are minors, have special needs, or are financially irresponsible, funding a trust with your 401K could be advantageous. An estate planning attorney can advise you on your best options.

Planning for Retirement? Schedule a Free Consultation

Make sure you get all the details right—always consult about setting up an estate plan. They can help you draft legally valid documents and make sure that your beneficiaries get the most out of their inheritance. Phelps La Clair has seven offices throughout the Phoenix area—contact us to schedule a meeting today. 

Photo by Fabrizio Coco on Unsplash used with permission under the Creative Commons license for commercial use 5/16/2024.