How to Reduce Income Taxes on an Inherited 401(k)

People who inherit a 401(k) are often surprised to learn they may have to pay taxes on the money. After all, inheritances are supposed to be exempt from income tax. The difference is that, unlike cash or non-qualified funds that you inherit, taxes were never paid on the money within a 401(k) account.

If you take some time to understand the tax consequences of your various options, you can minimize the amount of tax you have to pay on the inherited account without getting yourself into trouble with the IRS. Consult a tax professional to evaluate your individual situation and determine your best course of action.

The IRS taxes retirement accounts when the money is withdrawn. Most people are in a higher tax bracket when they're working than they will be when they retire, but that's not always the case. Planning ahead and taking distributions when you are in a lower tax bracket minimizes the amount of tax you'll pay. Inherited 401(k) distributions cannot be postponed indefinitely, however.

In most cases, a lump sum distribution of a retirement account results in the highest tax liability. The entire amount of the distribution is considered ordinary income subject to tax. A large 401(k) lump sum distribution could significantly increase your tax bracket, as well, so some or all of the money could be taxed at a higher rate than you usually pay.

If you inherit a 401(k) from your spouse, you can roll over the amount into your own IRA. This allows you to defer withdrawals, and thus taxes, until you reach age 70 1/2, at which time required distributions begin.

Distribution amounts are based on your lifetime rather than your spouse's. You can withdraw funds prior to that age, of course. They are taxed as ordinary income, and if you are younger than 59 1/2, the IRS will impose a 10 percent penalty.

Request a trustee to trustee transfer from the 401(k), so that the funds are sent directly to your IRA. If the funds are sent to you in a check, the plan may be required to withhold 20 percent for federal taxes; you must deposit the funds into your IRA within 60 days to avoid being taxed on the full amount of the check.

If you inherit a 401(k) from someone who was not your spouse, was younger than 70 1/2, and had not begun taking distributions, you can leave the money in the plan. You must, however, distribute the entire amount from the plan by the end of five years after the person died. Often this arrangement results in high taxes, for reasons similar to a lump sum distribution.

As a non-spouse, if you inherit a 401(k) from someone who had reached 70 1/2 and had begun taking required minimum distributions, you can still leave the money in the plan, but you must continue the distributions at the same frequency at which the deceased was taking them. The distribution amount is calculated based on federal life expectancy tables, using the table that applies to the younger of you or the deceased in the year of death.

Before you decide to keep an inherited 401(k) in the plan, contact the plan administrator. The five-year or required minimum distribution rules are set by the IRS; the 401(k) plan may require you to distribute the funds sooner. As an alternative, most plans will allow you to transfer the funds to an inherited IRA.

Transferring the 401(k) funds to an inherited IRA generally results in the lowest tax for non-spouse beneficiaries. Although you must begin distributions in the year of the death occurred, regardless of your age, the distributions are based on your life expectancy table. Since a beneficiary is typically younger than the deceased, the minimum distribution amounts are smaller, and the distributions are spread out over a longer time period. Additionally, the 10 percent penalty for early withdrawal from a retirement account is waived for an inherited 401(k) or IRA, regardless of your age.