Allworth Co-CEO Scott Hanson answers a reader's question about what to do with a financial windfall.
“I recently inherited a 401(k) with over $500,000 in it. The money is just sitting there because I keep feeling like I’m going to make a life-changing mistake. Can you help me?”
~Bonnie L.
First, Bonnie, I assume you inherited this money from a loved one, and so I want to extend my heartfelt condolences. As I’m sure virtually everyone reading this understands, losing someone is unimaginably difficult, and if it’s any consolation, my thoughts are with you.
At an absolute minimum, there are at least two positives that you can take away from having taken the time to ask this question. First, your loved one built a legacy through hard work and sacrifice, and passed it on to you, and that is something to be proud of and thankful for. Second, with tens of millions of 401(k) participants nationwide, and millions of listed beneficiaries, I know this question is one that a lot of people have, so you’re providing a valuable service to our readers.
Thank you.
Now, when someone inherits a 401(k), the rules vary. Mainly, however, your options depend on your relationship to the original account holder. So, prior to making your decision about what to do with the money in the account, as I don’t know all the specifics of your situation, please speak to an accountant and a fiduciary advisor. But let this serve as a primer for what you can ask your advisor. Knowing what to ask will help you get the most out of the meeting, and as there are a lot of large and small contingencies to consider, I promise the effort will be worth it several times over.
There are some foundational considerations regarding the decision-making process for inherited 401(k)s. These include:
- The account owner’s age at the time of death
- Your relationship (spouse, child, relative, caregiver) to the account holder
- Your age
- Your health
- What the specific 401(k) plan allows
Bonnie, while I’ll cover various scenarios, I’m going to assume that you inherited the 401(k) from your spouse.
So, first, you could simply declare yourself the owner of the 401(k), whereupon if your spouse had already started taking distributions, and depending on your age, you will continue to take them, or you could instead change course and just elect to take a lump-sum distribution. (Though, depending on the lump sum amount, and your other sources of income, the tax bump could be prohibitive.)
Please note, that if the money came from your spouse’s 401(k), whether you liquidate it all at once, or you take RMDs over time, no matter how old you are, you won’t have to pay any early withdrawal fees.
Now, if you have your own 401(k), depending on your age, you could also actually “roll” the inherited money into your account (no taxes would be due, so long as you never take control of the money). However, unlike the scenario above, once you co-mingle the money, IF you elect to take a withdrawal, and you are under 59½, then you ARE required to pay a 10% early withdrawal penalty.
Next, you could elect to roll the money into any number of inherited IRA vehicles, which encompass a wide variety of IRAs (SIMPLE, Roth, traditional, and others), each with its own unique treatments and requirements.
Another option would be, depending on your financial situation and your future estate intentions, to actually transfer the ownership of the 401(k) to someone else (a child, for instance), virtually washing your hands of the obligations, and thereby making them the beneficiary (this is more common than you might think).
As I’ve mentioned, the rules pertaining to inheriting a 401(k) from your spouse are complex, and while mistakes can be costly, education is key, and that means there are a wide range of options that allow for an outcome that best supports your unique financial scenario.
Now, while I don’t believe this is the situation, what if you inherited this 401(k) from someone who was not your spouse?
The rules surrounding 401(k) inheritances for non-spousal beneficiaries are significantly more straightforward than they are for spouses.
How so?
Let’s say that you are the child beneficiary, or other relative, or maybe even a friend, of the account holder. In this scenario, you are not permitted to move that money into your own IRA or co-mingle it with your 401(k). If, for instance, your auntie left you her 401(k), you can:
- Simply reject ownership of the account within nine months of the benefactor’s death (in which case it will pass to the secondary listed beneficiary, or to the estate).
- Or you could accept the account and – utilizing various withdrawal and distribution planning techniques – either take possession of the available funds all at once or over time, just so long as you do so by the end of the 10th year after the benefactor’s death.
As for the second bullet point, caveats include situations where you are legally disabled, you are the minor child of the original account holder, or you are less than 10 years younger than the account holder.
While the above is not comprehensive, it is an overview of the complex rules surrounding the inheritance of a 401(k), which were made even more complicated by the implementation of 2019’s SECURE Act and 2022’s follow up legislation, the SECURE 2.0 Act. I mention this primarily in the event that you, or someone you know, searches for information online. Simply, just make certain it’s up to date.
Good luck to you, Bonnie. Please reach out with any additional questions.