IRS issues warning on 25% penalty for non-compliant inherited 401(k) withdrawals

The US Internal Revenue Service has issued guidance warning that beneficiaries who fail to withdraw all funds from an inherited 401(k) within 10 years of the account holder’s death may face a 25% penalty on the remaining balance. This requirement is mandated by the Secure 2.0 Act for deaths occurring on or after 1 January 2020. The guidance highlights that non-spouse beneficiaries, particularly minors designated through a trust that winds down at the age of majority, face complex tax implications and strict distribution timelines. Experts advise consulting legal and financial professionals to navigate Required Minimum Distributions and avoid significant tax liabilities or penalties.

Under the Secure 2.0 Act, most non-spouse beneficiaries designated after 1 January 2020 must withdraw all funds from an inherited retirement account within 10 years of the original owner's death. Required Minimum Distributions may be required annually within this 10-year window, depending on the beneficiary's status. Eligible designated beneficiaries, which include minor children of the account owner until they reach the age of majority, disabled individuals, and those within 10 years of the owner's age, may be exempt from the 10-year rule and can stretch distributions over their lifetime.

The IRS considers children who are minors at the time they inherit a 401(k) to be eligible designated beneficiaries. Through a trust, they can receive payments through the 401(k) over the course of their entire lifetimes. However, if a minor’s trust ends at the age of majority, the beneficiary may be required to withdraw the entire balance quickly, potentially triggering significant immediate income tax liabilities. Inherited 401(k) funds cannot be rolled into a personal IRA; they must be transferred to an inherited IRA or withdrawn according to the 10-year rule.

If no trust is established for a minor beneficiary, a court will appoint a guardian or conservator, which can be costly and less controlled than a privately designated trustee. Alternative trust structures, such as conduit trusts or accumulation trusts, are suggested as methods to manage distributions and protect funds from creditors, though they carry their own tax implications. Inherited Roth IRAs may be exempt from income taxes on withdrawals, whereas traditional 401(k) and IRA withdrawals are treated as taxable personal income.

The article originally appeared on Moneywise.com under the title: Inheriting your late parent's 401(k) can trigger a 25% IRS penalty if you don't follow the withdrawal rules. This article provides information only and should not be construed as advice. It is provided without warranty of any kind.