Must 401(k) plan beneficiaries pay income tax on withdrawals?

Question:

I have a 401(k) plan that's worth about $100,000. Will my beneficiaries have to pay taxes or penalties if they withdraw this money when they inherit it after my death? Can they roll it over into another tax-deferred plan?

Answer:

After your death, the beneficiaries of your 401(k) plan will need to pay income tax on the money they take out. The exception is that if you had a Roth 401(k) plan, your beneficiaries won't need to pay tax on the withdrawals.

Why the difference? You put pre-tax money into a traditional 401(k), so that money was never taxed. On the other hand, Roth 401(k) contributions are made with post-tax money, so tax has already been paid.

The same is true if you yourself take money out of your 401(k) during your lifetime; you will pay income tax on the amount you withdraw each year unless it's a Roth 401(k).

After your death, if the beneficiary of your 401(k) is your spouse, your spouse will have a few options, such as rolling over your retirement plan into their own plan. They can also leave the 401(k) in your name, even after your death. What they decide to do will affect whether they need to begin taking distributions from your 401(k) and paying tax on those distributions. (See Naming Your Spouse to Inherit Retirement Accounts.)

Other (non-spouse) beneficiaries are required to withdraw all of the money in your 401(k) account within 10 years. If they don't, they will pay a significant penalty. A few exceptions exist; see How the SECURE Act Affects Your Retirement and Estate Plans to find out if your beneficiaries might fall into an exception that allows them to hang onto the 401(k) account longer.

While your beneficiaries can certainly take everything out in one lump sum, it might be wiser to spread out those withdrawals over those 10 years to minimize the income taxes paid.

Example: Your adult son inherits your entire 401(k). If he takes out the $100,000 all at once, that big chunk of extra income will kick him into a different tax bracket, and he will pay a higher rate of income tax. If he takes out $10,000 this year and each year after that (depleting the account within 10 years, as required by law), he pays tax on that withdrawal at a lower income tax rate and ends up paying less in tax overall.