3694 / What differences exist between the treatment of inherited IRAs and inherited 401(k)s?

While inherited IRAs often may be distributed over time (potentially spreading the associated tax liability over 10 years or the beneficiary’s lifetime), qualified plans (such as 401(k)s and profit sharing plans) are subject to a different set of rules that do not allow the funds to be distributed over time. As a result, when a taxpayer inherits a 401(k), the funds typically must be distributed immediately in a single lump sum payment, resulting in an immediate tax liability for the beneficiary. Most plans will specifically require lump sum distribution treatment because of the administrative burdens associated with allowing stretched out distributions.

Despite this, certain beneficiaries can roll those funds into an inherited IRA. Once the funds are in the inherited IRA, they must be distributed according to the same rules that govern inherited IRAs. While this option is now generally mandatory (under IRC Section 402; prior to 2010, a plan only had the option of allowing an inherited 401(k)-to-inherited IRA rollover), not all beneficiaries are eligible to roll inherited 401(k) funds into an inherited IRA.

Note that after 2020, once rolled into an IRA, the funds must be withdrawn within 10 years unless the beneficiary is an eligible designated beneficiary.

Only a designated beneficiary is entitled to take advantage of the option of rolling the inherited 401(k) funds into an inherited IRA. A designated beneficiary for this purpose means an individual, or certain trusts that qualify as “see through” or “look through” trusts. This means that the trust is an irrevocable trust that is valid under state law and identifies the beneficiaries of the trust as individuals (the trustee also must provide a copy of the trust document). The rollover must be accomplished in a trustee-to-trustee transfer (i.e., directly between the relevant financial institutions).

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Planning Point: Estates and other trusts that inherit a 401(k) are generally not designated beneficiaries for purposes of the distribution rules, so their distribution rights will be limited to those provided in the plan document itself.

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