Losing a loved one is never easy — and managing financial decisions during this time can add further stress.
Liam, 30, is coping with the sudden loss of his older sister. On top of the grief, he’s learned she made him the sole beneficiary of her 401(k) plan. While the balance is relatively modest — just over $10,000 — he’s unsure what to do next.
He could use the funds to pay off debt, but he’s also considering the possibility of keeping the money invested for long-term investment.
If you’re in a similar situation, here’s what you need to know about handling an inherited 401(k) — and how to prepare in advance so you’re financially ready when facing loss.
Must Read
- Thanks to Jeff Bezos, you can now become a landlord for as little as $100 — and no, you don’t have to deal with tenants or fix freezers. Here’s how
- I’m 49 years old and have nothing saved for retirement — what should I do? Don’t panic. Here are 6 of the easiest ways you can catch up (and fast)
- Dave Ramsey warns nearly 50% of Americans are making 1 big Social Security mistake — here’s what it is and 3 simple steps to fix it ASAP
What happens to a 401(k) when someone passes away?
When someone opens a 401(k), they’re asked to name one or more beneficiaries. If no beneficiary is listed, the account typically goes through probate — a lengthy and often costly legal process that may result in the funds going to someone the deceased never intended.
For married couples, 401(k) assets usually pass automatically to the surviving spouse, unless the spouse has signed a waiver allowing someone else to be named.
For single individuals, it’s especially important to be explicit about a beneficiary — otherwise, the account could default to next of kin, which may exclude a partner, friend, or sibling.
In Liam’s case, his sister may have named him because she felt her parents were already financially secure, and likely didn’t expect to pass away before them.
With over 40% of U.S. adults living without a spouse or partner, according to the Pew Research Center, clearly designating beneficiaries is a crucial part of estate planning.
Once a beneficiary is named, they typically have the option to move the 401(k) into an inherited IRA. Under current IRS rules, most non-spouse beneficiaries must withdraw the full balance within 10 years, and all distributions are subject to income tax.
However, some individuals qualify as Eligible Designated Beneficiaries (EDBs), which allows them to take required minimum distributions (RMDs) over their life expectancy instead of following the 10-year rule.
EDBs include:
- Surviving spouses
- Minor children (until age 21)
- Disabled or chronically ill individuals
- Beneficiaries less than 10 years younger than the account holder
If Liam has a disability or is close in age to his sister, he may qualify for an EDB. This option could help reduce his annual tax burden; however, RMD amounts vary based on age, IRS tables, and other factors. Therefore, it’s worth consulting a financial advisor to evaluate the best path forward.
Read more: US car insurance costs have surged 50% from 2020 to 2024 — this simple 2-minute check could put hundreds back in your pocket
Withdrawing the 401(k)
Liam generally has 10 years from the date of his sister’s death to fully withdraw the funds from the inherited 401(k), once it’s transferred into an inherited IRA. All withdrawals are subject to income tax, but no early withdrawal penalties apply because the account was inherited.
If Liam withdraws the money now while his income is low,his tax burden may be minimal. However if he’s a high earner, a portion of the $10,000 could be lost to higher tax rates.
While he can use the money now, leaving it invested could allow for meaningful growth. According to Investopedia, the average five-year return for 401(k) accounts was 9.7% as of 2023. At that rate, the $10,000 could potentially grow to more than $25,000 in 10 years — thought returns are never guaranteed.
If Liam doesn’t urgently need the funds, letting the investment grow could provide a helpful boost to his long-term financial goals. Once withdrawn, he could reinvest it into his own retirement savings for continued growth.
Spousal survivor benefits vs. non-spouse beneficiaries
Spouses who inherit a 401(k) have more flexibility than non-spouse beneficiaries like Liam. For example, a surviving spouse can:
- Roll the inherited 401(k) into their own IRA or 401(k)
- Transfer it to an inherited IRA and take required distributions based on life expectancy
- Take a penalty-free lump sum distribution
Unlike non-spouse beneficiaries, surviving spouses can also make new contributions if they roll the funds into their own retirement account. However, the rules are complex and the best choice depends on factors like the spouse’s age, the age of the deceased, and when distributions are taken.
If you’ve inherited a 401(k) and aren’t sure what to do next, a financial advisor can help you understand your options, align them with your goals, and minimize taxes.
What to read next
- How much cash do you plan to keep on hand after you retire? Here are 3 of the biggest reasons you’ll need a substantial stash of savings in retirement
- There’s still a 35% chance of a recession hitting the American economy this year — protect your retirement savings with these 5 essential money moves ASAP
- This tiny hot Costco item has skyrocketed 74% in price in under 2 years — but now the retail giant is restricting purchase. Here’s how to buy the coveted asset in bulk
- Want an extra $1,300,000 when you retire? Dave Ramsey says this 7-step plan ‘works every single time’ to kill debt, get rich in America — and that ‘anyone’ can do it
Join 200,000+ readers and get Moneywise’s best stories and exclusive interviews first — clear insights curated and delivered weekly. Subscribe now.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.