What Happens to Your 401(k) and IRA When You Die -- What Heirs Need to Know
Key Points
A surviving spouse is automatically the beneficiary of a 401(k) unless they sign their rights over.
Non-spouse beneficiaries have different tax rules than surviving spouses.
Inherited 401(k)s receive a unique tax break with net unrealized appreciation that IRAs don't.
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Dealing with death is already emotionally and mentally tough, but unfortunately, the financial side of it isn't always straightforward and easily dealt with. The implications depend on your relationship with the deceased, the types of assets left behind, and the accounts those assets are held in.
The most common accounts left behind are retirement accounts like 401(k)s and IRAs because many working adults have them. They can be a financial blessing to those they're left behind, but it's important to understand where they function similarly and differently. The difference could alter how you treat them.
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Your relationship to the deceased person matters
The exact rules for how you have to treat an inherited 401(k) or IRA depend on whether you're the surviving spouse, designated beneficiary, or eligible designated beneficiary.
Surviving spouse
As the surviving spouse, many 401(k) plans automatically make you the full beneficiary of your spouse's account unless you legally sign your rights to it away. For an IRA, the plan owner must designate their beneficiary.
If you're receiving an inherited 401(k), you have the option to roll it over into your own 401(k) if your plan allows it, or into an IRA. If you're receiving an IRA, you can also roll it over into your own retirement account or choose to keep the assets separate and transfer them into a new plan. The latter creates an inherited IRA.
Most 401(k) plans will require that you take a lump sum distribution within a certain time frame of receiving the account. The exact length of time is plan-specific, though.
Designated beneficiary
Designated beneficiaries are non-spouses, such as children, grandchildren, siblings, friends, etc.
If you fall into this category and receive an inherited 401(k), you can not roll it over into your own 401(k) or IRA. You must do a direct trustee-to-trustee transfer into an inherited IRA. If you take a withdrawal (whether accidental or on purpose), you'll owe taxes on the amount withdrawn.
You also can't roll over an IRA; it must be transferred to an inherited IRA. And once it is, you can't add to it.
A major difference between designated beneficiaries and a surviving spouse, however, is that most designated beneficiaries must withdraw all funds from the IRA by the 10th year after someone dies. For example, if someone were to pass away this year, a designated beneficiary would have until Dec. 31, 2036, to withdraw the full balance of the account. However, there's an exception, as described below, for certain beneficiaries.
Eligible designated beneficiary
Eligible designated beneficiaries (EDBs) are people who are within 10 years of age of the deceased person, disabled or chronically ill, or a minor child. The rules are the same for a 401(k) as if you were a designated beneficiary, but when it comes to IRAs, the difference is that you're not subject to the 10-year rule.
EDBs are typically allowed to take withdrawals over their life expectancy, except for minor children. Their 10-year clock begins the year they turn 21.
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A unique 401(k) tax break
Net Unrealized Appreciation (NUA) is the difference between the cost basis of employee stock and that stock's current market value.
If someone passes away with company stock in their 401(k) that has greatly appreciated (say they worked for Nvidia for the past 20 years), the stock receives a special tax break. You can transfer the stock into a taxable brokerage account and pay taxes based on the original cost basis rather than the current market price.
Depending on just how much the stock has appreciated, doing so could easily save tens of thousands in taxes. Unfortunately, though, this tax break is reserved for 401(k)s. It doesn't apply to IRAs, but you won't need it, since those assets typically have their basis set to their value at death.
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Stefon Walters has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.
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