Inheriting a 401(k) or IRA? 3 Moves That Can Lead to a Tax Headache
If you recently inherited a 401(k) or IRA, one wrong move could trigger a much larger tax bill than expected. These accounts come with strict withdrawal rules, and the best decision often depends on the type of account, your relationship to the original owner and your income.
Before you cash out, move the funds or decide how much to withdraw, here are three moves financial experts say to avoid.
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Cashing Out Too Quickly
“The most common tax mistake is cashing out the account too quickly,” said Sherman Standberry, the CEO and managing partner at My CPA Coach.
Inherited retirement money does not automatically become tax-free just because it’s passed down. If it was originally funded with pre-tax dollars, you, the beneficiary, may owe income tax when you withdraw the funds.
“Depending on the type of account, the assets can be taxable as ordinary income," continued Standberry. "For example, pre-retirement assets like traditional 401(k)s or traditional IRAs are taxable when withdrawn, even if it's from an heir.”
Withdrawing could also increase your tax bracket. Akirashanti C. Byrd, co-founder and co-owner at Curl Centric, shared the following example: "If you inherited a traditional IRA valued at $200,000 and you earn $75,000 per year, you just pushed yourself into the 22% or even 24% bracket on a big chunk of that inheritance."
Instead, Byrd recommended spreading out withdrawals over a 10-year period. As she explained, “It keeps your taxable income from spiking in a single year and gives you room to actually keep more of what you inherited."
Misunderstanding the 10-Year and RMD Rules
Daniel Gleich, a board member and shareholder at Madison Trust Company, said that when inheriting a 401(k) or an IRA, many beneficiaries struggle to understand the rules around required minimum distributions (RMDs) timelines.
“Many non-spouse beneficiaries are subject to the SECURE Act’s 10-year distribution requirement and misunderstanding this deadline can potentially result in tax penalties,” he said.
For designated beneficiaries subject to this rule, the inherited account must be fully distributed by December 31 of the tenth year after the year the account holder passed. But, according to Gleich, if the account owner had reached their time to start taking RMDs before they passed, then the beneficiary will also be required to continue taking RMDs during the 10-year period.
George Dimov, a certified public accountant (CPA) and president of Dimov Tax Specialists, said that the IRS initially gave a break on penalties from 2021 through 2024, but that’s over. “Starting in 2025, if you miss one, you'll get a 25% penalty on the amount you should have taken."
Ignoring Employer Plan Distribution Rules
Another costly tax mistake is not paying attention to your employer’s 401(k) rules.
“Many employer plans make you take the money out faster than the IRS requires. Sometimes they even make you take it all at once," said Dimov. "If you inherited a 401(k), roll it into an inherited IRA first. This way, you get to keep the IRS timeline and avoid a taxable distribution that your old employer's plan would have forced on you.”
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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