The rules surrounding the distribution of a deceased’s 401(k) depend on whether the beneficiary is a surviving spouse or child.

Income tax must always be paid on withdrawals and distributions from a 401(k) because a withdrawal or distribution from a 401(k) is added to your taxable income for the year.

Options for a 401(k) Spousal Beneficiary Non-spousal Beneficiary
Lump Sum Payment X X
Separate Payments Over Five (5) Years X X
Continue Withdrawing from 401(k) X X
Rolling 401(k) Funds into own IRA X  

Lump Sum Payment

A surviving spouse or non-spousal beneficiary may choose to receive the 401(K) in a lump sum payment. Under this type of distribution, the beneficiary gets one (1) lump sum payment of the remaining amount in the original account holder’s 401(k). Many plans decide automatically to make a lump sum distribution because the plan does not want to have to use recourses to keep track of the account.

The beneficiary will not be subject to an early withdrawal penalty regardless of the age of the beneficiary and whether the beneficiary is a spouse or non-spouse.

Inherited IRA

A surviving spouse or non-spousal beneficiary may transfer an inherited 401(k) into an IRA established in the name of the deceased original account holder’s name. The IRA in the name of the deceased original account holder’s name is treated as an inherited IRA. An inherited IRA must be maintained separately from the beneficiary’s other IRAs.

The funds from the 401(k) must be transferred directly to the inherited IRA so that the beneficiary never touches the funds. Otherwise the transfer may be voided, and the funds will be taxed as a lump sum in that year.

Distributions must begin the year following the donor’s death, regardless of whether the beneficiary is retired or not. The beneficiary will not face the ten (10%) percent early withdrawal penalty for withdrawing funds from the IRA even though the beneficiary is not 59 ½ years of age. Receiving the payment over a number of years allow the beneficiary to spread out the tax hit. That is the tax hit from the distribution being counted as part of the beneficiary’s taxable income.

Distributions are made in accordance with the required minimum distribution (RDM) rules. Under the RDM rules, the beneficiary must withdraw a certain amount each year from the inherited IRA. If the RDM is not withdrawn, the IRS will impose a penalty equal to fifty (50%) percent of the difference between the RMD and what was actually withdrawn. The amount the beneficiary must withdraw depends on whether the original account holder has reached the mandatory withdrawal age of 70 ½.

A. Separate Payments Over Five (5) Years

If the original account holder has not reached the mandatory withdrawal age of 70 ½, then the beneficiary may receive separate payments over five (5) years after the death of the original account holder. Alternatively, the beneficiary may choose to have the payments distributed over his or her life.

If the original account holder has already reached the mandatory withdrawal age of 70 ½, then the beneficiary does not have the option of receiving distributions over a five (5) year period.

B. Continue Withdrawing

If the original account holder has already reached the mandatory withdrawal age of 70 ½, then the beneficiary may continue to withdraw funds from the 401(k). The beneficiary’s minimum annual withdrawal amount is based on life expectancy, which is determined according to IRS tables.

The beneficiary has two options when choosing to continue withdrawing based on life expectancy. The beneficiary may choose to continue withdrawing based on:

  1. The Life Expectancy of the Beneficiary, or
  2. The Life Expectancy of the Original Account Holder.

Rolling The Funds Into The Spouse’s Own IRA

Only a surviving spouse is allowed to roll over the balance of the deceased’s 401(k) into an existing or new IRA in their own name.

The key advantage of the surviving spouse rolling over the deceased’s 401(k) is that the surviving spouse does not have to begin taking mandatory withdrawals until he or she reaches the age of 70 ½. In other words, the surviving spouse can avoid paying income taxes on the 401(k) until the surviving spouse begins to receive distributions. However, a surviving spouse must report the amount of the 401(k) rolled over on IRS Form 1099-R.

However, if the surviving spouse is under the age of 59 ½ and decides to withdraw from a spousal rollover IRA, the surviving spouse will not only have to pay the income tax on the amount but will also have to pay an early withdrawal penalty of ten (10%) percent.

Note: It is important for the surviving spouse to have the 401(k) rolled directly into his or her own IRA. If the distribution is paid to the surviving spouse, the distribution is subject to a mandatory income tax withholding of twenty (20%) percent, even if the surviving spouse intends to roll the distribution over. Besides the distribution being subject to the mandatory income tax withholding, the surviving spouse only has sixty (60) days from the date the distribution is received to roll it over into his or her own IRA. Additionally, if the surviving spouse does roll the distribution over and wants to defer tax on the entire distribution, the surviving spouse will have to add funds from other sources equal to the amount withheld.

Jena is an Attorney & Counselor at Law whose primary areas of practice are Tax Law and Estate Planning and is located in Lafayette, LA