When you die your 401k becomes part of your estate and is ultimately transferred to your beneficiaries. When you open your 401k at least one beneficiary is named who will inherit the funds upon your passing. If no beneficiary is named the 401k becomes part of your estate.

If your spouse is the named beneficiary of the 401k, he or she would be able to roll it into their own 401k or IRA. The advantage is that your spouse will avoid the early withdrawal penalty.

What is the 401k Early Withdrawal Penalty?

One of the benefits of putting money into a 401k is the ability to avoid tax on the contribution. The amount you contribute is not taxed. However, you pay tax when you withdraw the funds.

You should also be aware that the 401k withdrawals could be subject to a penalty if you withdraw the funds before you reach 59 1/2. This penalty should be avoided if at all possible. The last thing you want is to spend years investing your hard-earned money only to flush 10% of it away to this additional tax.

The IRS allows several exceptions to this early withdrawal penalty including inheriting the 401k. Other exceptions include distributions due to:

  • Departure from your job in the year your turn 55 (age 50 for public service employees)
  • Medical costs
  • Military reservists called into active-duty service
  • IRS levies
  • Certain birth or adoption costs
  • Substantially equal payments over your life expectancy
  • Qualified domestic relations court order (QDRO)
  • Disability

Special Rules for Non-Spouse Beneficiaries

There are special rules for 401k inherited by non-spouses. If the original 401k account holder dies in, or after, 2020 the non-spouse beneficiary can rollover the funds into an inherited IRA but they must withdraw the money within 10 years.

Traditional IRA rules require that at least some of the funds be withdrawn in the year the owner turns 73. These withdrawals, known as required minimum distributions (RMD), will need to be made by the beneficiary with an inherited IRA will as if the original account holder was still alive.

If the beneficiary of the 401k is a minor, then he or she can withdraw the funds within the 10-year window or take distributions over their life expectancy until they reach 21 years old and then a complete distribution within the next 10 years.

Tax on the 401k withdrawals would be paid at the beneficiary’s tax rate so this creates an opportunity for thoughtful planning and tax savings.

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