A lot of children assume they\u2019ll get their inheritance from parents in a will. But there are other ways to inherit wealth, like as the designated beneficiary of a loved one\u2019s 401(k) or IRA.<\/p>\n
The upside of inheriting a retirement account is that it\u2019s not subject to probate, unlike other assets outlined in a will. But the accounts may be subject to other conditions. That\u2019s where things get complicated.<\/p>\n
Must Read <\/p>\n
Imagine someone like Drew, whose father Brian raised him alone. Sadly, Brian died of cancer in his late 40s while Drew was still in high school. Brian had designated his son as a beneficiary of his 401(k) through a trust.<\/p>\n
Drew\u2019s uncle Jim took him in and served as estate trustee, waiting for Drew to reach the age of majority, which he\u2019s about to do as he\u2019s turning 18.<\/p>\n
Up until now, Jim has been tight-lipped about the 401(k). Drew wants to know how much it is, if he should cash it in, let it grow or if there are other options. There\u2019s a lot to consider \u2014 legally and financially.<\/p>\n
Options for children who inherit retirement accounts <\/p>\n
In this case, Drew would be considered a \u2018non-spouse\u2019 beneficiary (1) of the 401(k). Non-spouses have a few options when it comes to inherited 401(k)s, IRAs and Roth IRAs.<\/p>\n
It\u2019s wise to consult a lawyer and a certified financial planner or CPA because each option carries legal and tax implications.<\/p>\n
Read More: Here\u2019s the average income of Americans by age in 2026. Are you falling behind?<\/a><\/p>\n Option 1: Receive money through a trust <\/p>\n The IRS considers children who are minors at the time they inherit a 401(k) to be \u2018eligible designated beneficiaries (2).\u2019 This category also includes people with disabilities or chronic illnesses. Through a trust, they can receive payments through the 401(k) over the course of their entire lifetimes.<\/p>\n While Drew\u2019s father set up a trust for Drew, he set it up as a minor\u2019s trust (3), one that would wind down when Drew reached the age of 18.<\/p>\n That means Drew can receive money from the 401(k) \u2014 potentially all of it \u2014 this year. It also means he has to withdraw it within a certain amount of time.<\/p>\n Option 2: Cash in the inherited account <\/p>\n This may appeal to someone like Drew who wants to go to college. The problem is that cashing in an inherited 401(k) or IRA all at once will immediately trigger higher taxes. It\u2019s considered personal income. It may bump you up into a higher tax bracket.<\/p>\n Story Continues <\/p>\n The income taxes may be waived in the case of some inherited Roth IRAs.<\/p>\n Option 3: Transfer an inherited 401(k) into an inherited IRA and let it grow <\/p>\n Drew doesn\u2019t have the option to transfer it into an IRA because he wasn\u2019t named as a beneficiary of an IRA or Roth IRA. He only inherited a 401(k).<\/p>\n For children who inherit both a 401(k) and an IRA from someone who has died since Jan. 1, 2020:<\/p>\n You can only transfer (4) your inherited 401(k) funds to your inherited IRA account. You can\u2019t roll it into your own personal IRA.<\/p>\n If your loved one died any time from Jan. 1, 2020 onward, you must withdraw all funds out of the inherited IRA account within 10 years of your loved one\u2019s death via Required Minimum Distributions (RMDs) per the federal Secure 2.0 Act (5). If you don\u2019t, the IRS can charge a 25% penalty (1) on the amount that remains in the account. One way to limit the tax impact of this is to withdraw more in years when you earn less, say if you are laid off or take a sabbatical.<\/p>\n What to consider if you name a child as beneficiary of your 401(k) <\/p>\n If you\u2019re planning to designate a child as a beneficiary of your 401(k) or an IRA, be aware that if you die before the child has reached the age of majority in their state (usually 18, sometimes 21), someone will have to guard the account while the child is a minor.<\/p>\n If you want to handpick the guardian, you must set up a minor\u2019s trust and name a trustee. If you don\u2019t, the court will choose (6) a guardian or conservator for you. As the law firm Hellmuth & Johnson notes, that\u2019s costly.<\/p>\n You may also want to set some conditions on the release of the funds when your child turns 18, if you are concerned about their inheriting a lot of cash at a young age. Not only could that present a tax liability, but a personal financial risk if they\u2019re not knowledgeable about how to spend a windfall responsibly.<\/p>\n You can set up a conduit trust (6) to protect the 401(k) even after the child turns 18, with the trust releasing RMDs to the child at regular intervals. A trustee could release more funds to the child upon request, but it would be at the trustee\u2019s discretion \u2014 not the child\u2019s..<\/p>\n Alternatively, you could set up an accumulation trust, in which RMDs would flow to the trust and may or may not be released to the child. The funds would still have to be withdrawn by the time the child is 31. The upside is that this kind of trust may protest the funds from outside creditors. But it comes with major tax implications if there are any funds remaining the the trust when the child turns 31.<\/p>\n Before proceeding with any option, make sure you are aware of all the legal, financial and emotional impacts. The goal is to transfer wealth, not headaches, to the next generation.<\/p>\n You May Also Like <\/p>\n Join 250,000+ readers and get Moneywise\u2019s best stories and exclusive interviews first \u2014 clear insights curated and delivered weekly. Subscribe now.<\/a><\/p>\n Article Sources <\/p>\n We rely only on vetted sources and credible third-party reporting. For details, see our ethics and guidelines<\/a>.<\/p>\n Fidelity Investments (1)<\/a>; Internal Revenue Service (2)<\/a>; Copenbarger & Copenbarger (3)<\/a>; Thrivent Financial (4)<\/a>; Sartorial Wealth (5)<\/a>; Hj Law Firm (6)<\/a><\/p>\n This article originally appeared on Moneywise.com<\/a> under the title: Inheriting your late parent’s 401(k) can trigger a 25% IRS penalty if you don’t follow the withdrawal rules<\/a><\/p>\n This article provides information only and should not be construed as advice. It is provided without warranty of any kind.<\/p>\n","protected":false},"excerpt":{"rendered":"A lot of children assume they\u2019ll get their inheritance from parents in a will. 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