Despite bringing you extra money, inheriting a 401(k) isn't an exciting event because it means you lost someone close to you. The Internal Revenue Service doesn't make it worse because you won't owe any additional penalties for cashing out an inherited 401(k) plan. However, depending on the type of 401(k), you may still owe income taxes.
No Early Withdrawal Penalty
Typically, when you cash out money from a 401(k) plan before you turn 59 1/2 years old, the IRS imposes an extra 10 percent tax penalty -- on top of ordinary income taxes -- on the taxable portion of your withdrawal. However, one of the very few exceptions to the penalty occurs when the 401(k) plan makes the distributions to a beneficiary after the original account holder dies. So no matter how old you are, if you receive a distribution from an inherited 401(k) plan, you don't owe the extra penalty.
Traditional 401(k) Withdrawals
Even though you're off the hook for the penalty, the exception doesn't excuse you from income taxes. When you're withdrawing from an inherited traditional 401(k) plan, the entire withdrawal counts as taxable income unless the decedent made nondeductible contributions -- which are rare. For example, if you take out $7,000 from an inherited 401(k) plan, you must report an additional $7,000 of taxable income on your income taxes for the year.
Roth 401(k) Withdrawals
If you inherit a Roth 401(k), you might get off the hook for taxes on some or even all of the distributions. If it's a qualified distribution, meaning the Roth 401(k) plan was open for at least five years before the decedent's death, you won't pay taxes on any of the money you take out. If, however, it wasn't open for five years, each distribution is split between nontaxable contributions and taxable earnings, based on the proportion of each in the account. For example, if the 401(k) has 60 percent contributions and 40 percent earnings when you take the distribution, only 40 percent of the withdrawal is taxable.
Tax Rates on Withdrawals
Taxable distributions from a 401(k) plan count as ordinary income, which means they're taxed at the same rates as wages, salaries or interest income. Because the IRS uses a progressive tax rate structure, the more additional income you have, the higher the tax rate on your 401(k) withdrawal. For example, if you fall in the 10 percent tax bracket, a $1,000 withdrawal costs you $100 in taxes. But if you're in the 28 percent bracket, that same $1,000 withdrawal costs you $280 in taxes.
- Creatas/Creatas/Getty Images
- Early Withdrawals From a 403(b) Plan
- How Much Tax Is There When Withdrawing a 403(b)?
- Pre Tax Vs. Roth 401(k)
- Rules Governing Withdrawals From IRA Accounts
- Are 401(k) Withdrawals Taxable?
- When Can You Withdraw From a 457 Deferred Compensation Plan?
- 401(k) Withdrawals for Medical Surgery
- How Much Tax Do I Have to Pay After Liquidating My IRA?