How Much Income Tax Will I Have to Pay on an Inherited 401(k)?

Question and background:

How much income tax will I have to pay on an inherited 401(k)? It was $1,790,000. I got it from my dad when he passed.

Answer:

My condolences in the passing of your father.

In answering, I’ll assume that you are the sole “designated” primary beneficiary and that all your father’s contributions to the 401(k) were pre-tax.

Any amounts you withdraw (“distribute”) will be taxed as ordinary income…both federal and state (if applicable). So the income tax you end up paying will depend on your other taxable income and how much you distribute in any particular year. If you distribute large amounts, you could easily push yourself into one of the higher (or highest) income tax brackets. This is a very large retirement account and I recommend that you enlist the help of a fee-only advisor and do some planning to minimize the overall tax bite.

Also be aware of several important issues:

If your father had not yet reached his “Required Beginning Date” (April 1 after the year he turned 70 ½):

a) You can take “Required Minimum Distributions” (RMDs) over your own life expectancy, but the choice and first distribution must be taken by the end of the year after the year your father died, or

b) If you choose not to take distributions over your own lifetime, you can distribute any amount as long as the entire account is empty by the end of the 5th year following your father’s death.

If your father had reached his Required Beginning Date:

a) You can take Required Minimum Distributions over your own life expectancy but must take the first distribution by the end of the year after the year your father died.

b) Any Required Minimum Distribution that your father hadn’t yet taken for the year he died must be taken by you as beneficiary rather than be paid to your father's estate. So you will pay income taxes on that distribution rather than his estate.

You can always distribute more than the required minimum, just not less. Distribute less and you’ll get hit with a 50% federal penalty tax (yes, 50%!) on the amount you failed to take, plus you’ll still have to take it and pay taxes on it anyway.

It’s often beneficial to roll an Inherited 401(k) to an Inherited IRA. Why? A broader range of investment options and more control. But be sure it’s a direct custodian-to-custodian transfer and that you don’t take possession of the funds. It’s also critical that the destination Inherited IRA be properly titled. Incorrect titling can destroy an Inherited IRA, making it fully taxable. The IRA custodian will have their preferred titling format.