If You Inherit A 401k, Don't Ignore This Important Rule

The financial aspects of retirement planning are complex and involve many unique factors that impact savers in countless ways. The choice to use a 401(k), Roth IRA, or some other tax-advantaged account is just one of those decisions in a rapidly expanding tree. If savers inherit a 401(k), they face yet another set of considerations. Inheriting the remaining assets of a loved one comes with plenty of financial benefit, but also with lots of rules. One important regulation governing inherited 401(k) accounts stipulates that while spouse beneficiaries can follow a Required Minimum Distribution (RMD) schedule based on their life expectancy, most non-spouse inheritors must abide by the 10-year rule. The 10-year rule was passed with Section 401 of the 2019 SECURE Act, which amended the corresponding section of the Internal Revenue Code (IRC). RMDs are an important figure to check before the end of the year, but a far more pressing issue awaits many inheritors who are left assets in a 401(k).

This rule alleviates the need to draw out funds at a steady pace, allowing you to leave the assets untouched for longer. However, if you've been left money in a 401(k) by someone other than your spouse, with a few exceptions, you'll have to deplete the account by the end of the tenth year following the original owner's death or face stiff penalties to the tune of 25% on the remaining value, per the IRC (via Cornell Law School). Fortunately, this is a long enough window to plan out a reasonable strategy for taking over the assets in a way that makes sense in the context of your finances.

If you're a non-spousal beneficiary, you are most likely subject to the 10-year rule. However, you have three options for dealing with the inherited 401(k). You can take a lump sum distribution, in which case the 10-year rule is satisfied immediately. Alternatively, you can transfer the funds into an inherited IRA (per IRS Publication 590-B), or leave the assets in their current state; these non-immediate drawdown options come with a stipulation that the funds are withdrawn by the end of the tenth year. RMDs are not required of inheritors subjected to this rule, but you'll need to clear the account entirely within 10 years, one way or another. If the assets are in a traditional 401(k), this can mean a tax obligation, whereas a Roth account won't yield additional taxes. 

The 10-year window allows for ample planning, especially if you're dealing with pre-tax dollars and will be taxed on the distributions. The key is to act quickly. The longer you wait, the fewer options you'll have when moving the assets. Waiting also brings about a greater likelihood of ultimately passing the deadline and taking in a punishing 25% haircut on the remaining value.

Apart from spousal beneficiaries, minor children and disabled or chronically ill inheritors (and those less than 10 years younger than the original owner when they died; perhaps a cousin or sibling) can take RMDs and delay or avoid the countdown. But once a child is no longer a minor, the 10-year rule's clock begins. For all inheritors of 401(k) dollars, the 10-year rule comes into effect for original account owners who died in 2020 or later, so 401(k)-based inheritances that took place before the 2019 SECURE Act came into force are not subject to this new guidance.