Inherited a fat 401(k)? 4 things to know

Inherited a fat 401(k)? 4 things to know

Inherited a fat 401(k)? 4 things to know

If you've just inherited a fat 401(k) from a deceased relative, you may not know how to proceed. You might be able to leave the money where it is, but this isn't always a smart decision. Often these accounts can have six to seven figure balances, as tracked by Fidelity.

Worse even: If you don't understand how the money will be taxed, you could end up losing a larger share of your inheritance to the government than you needed to.

Here are four things you need to know about inherited 401(k)s if you're the named beneficiary.

1. How beneficiaries are chosen

By law, your spouse is designated as your 401(k) beneficiary, unless he or she is already deceased or signs a waiver giving up his or her right to the money. Then, you can leave the money to any other family member, friend, or group that you want to.

It's important to keep your beneficiaries up to date because if no surviving beneficiaries are listed when you die, the money will go to your estate instead, which can restrict how your heirs can take distributions.

For example, the plan may require heirs to the estate to withdraw the money in a lump sum, forcing them to pay taxes on the full amount in a single year, whether they want to or not.

2. Spouses can roll over funds into their own accounts

Surviving spouses have the same distribution options as non-spouse beneficiaries (more on those below), but they also have the option to roll over the funds into their own IRA. The main reason people choose to do this is because they can delay required minimum distributions (RMDs).

These are mandatory withdrawals from all retirement accounts except Roth IRAs that the government forces individuals 70 1/2 and over to take in order to ensure it gets its tax cut. You can withdraw more than this amount per year if you'd , but if you withdraw less, you'll pay a 50% penalty on the amount that you should have withdrawn.

RMDs are determined by the value of the account and the age of the account owner.

If you do not roll over the 401(k) to an IRA in your own name, you will have to begin taking RMDs when your spouse would have turned 70 1/2, or if he or she was already 70 1/2 or older, you will have to continue taking distributions the age that your spouse would have been in that year. You can figure out how much you need to withdraw using this table. Simply divide the total value of the account by the distribution period for the age your spouse would be today if he or she was still alive.

The problem with this approach is that the RMDs may force you to take out more money than you'd to, possibly pushing you into a higher income tax bracket where you will lose more of your inheritance to the government.

While you can't put off RMDs forever, you can delay them by transferring the money from your deceased spouse's 401(k) to an IRA in your own name. Then, you won't have to take any RMDs until you reach 70 1/2. You also won't have to pay any taxes on the money until you withdraw it in your own retirement.

Of course, if your deceased spouse was younger than you, you may be better off not rolling over the 401(k) because then you can delay RMDs until your spouse would have turned 70 1/2.

The downside of rolling over an inherited 401(k) to an IRA is that, if you're under age 59 1/2, you can't touch the money once you've rolled it over without incurring a 10% early withdrawal penalty, unless it's for a qualified reason. So if you need the funds now, you're better off going with one of the other methods below.

3. You can roll the money into an inherited IRA

The most popular option for non-spouse beneficiaries is to roll the money into an inherited IRA. If there are multiple beneficiaries, each can have their own inherited IRA with a share of the money.

This is a new account set up in your own name, so you are able to designated beneficiaries of your own. Un regular IRAs, though, you're able to take distributions from this account when you're under age 59 1/2 without incurring a 10% early withdrawal penalty.

But you still have to pay income tax on the money, unless it came from a Roth 401(k).

You can take your distributions in one of three ways: Withdraw it all at once, spread the withdrawals over five years, or take RMDs your own life expectancy. This last option is the most popular because it enables you to spread the taxes out across many years rather than paying for it all in a single year. Plus, it allows the money to remain in the IRA for longer and continue to grow.

Your RMDs for an inherited IRA or 401(k) are the IRS Single Life Expectancy Table. You look up your age and the life expectancy factor associated with it. Then, you divide the total value of the account by this number.

So if you are 35 and the account that you're inheriting is worth $100,000, you would look on the table and find that the life expectancy factor for age 35 is 48.5. So you would divide $100,000 by 48.5 and end up with $2,061.86.

This is the minimum amount you would have to withdraw this year in order to avoid penalties. Next year, you would do the same thing, but this time with the life expectancy factor for age 36.


4. You may be able to leave the money where it is

While the easiest thing to do when you inherit a 401(k) is to leave it where it is, this is rarely the smartest decision.

For one, if you leave the 401(k) where it is, you'll have to take RMDs the original owner's life expectancy if you don't withdraw the money in a lump sum or within five years. You also don't get to choose your own beneficiaries for the money when you leave it. If you were to die unexpectedly, that money would go to your estate.

It's also worth noting that depending on the 401(k) plan, you may not be allowed to leave the money where it is.

The deceased's employer will also get a say in how the money is handled, and some may require that the money be distributed in a lump sum or by the end of the fifth year following the employee's death.

Look into the rules for the deceased's 401(k) plan to see if there are any restrictions on how you can take the distributions before you decide on a withdrawal strategy.

However you choose to handle your inherited 401(k), it's important to make sure that you understand the tax implications of your decision so you don't have any unpleasant surprises come tax time.

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You Can’t Save Too Much In Your 401(k) For Retirement

Inherited a fat 401(k)? 4 things to know

Are you wondering whether you can save too much in your 401(k)? After all, if you save so much in your 401(k), you might not have a large enough taxable investment portfolio to generate passive income before 59.5. However, the reality is, you can’t save too much in your 401(k) if you follow my guidelines.

One of the reasons why I started the Financial Samurai Forum was to extend the number of wonderful discussions we have on this site. Instead of letting me dictate what we talk about on any particular day, the community gets to decide what it wants, whenever it wants.

The FSF is reaching financial independence for your inquisitive mind!

For example, a Financial Samurai Forum member David is wondering whether it’s possible to have too much in his family’s 401(k) account. Here’s what he writes:

My wife and I are both around 50 years old. We want to be able to retire at 55. We max our 401(k) contributions each year and have a pretty good chunk in 401Ks – approximately $2.5M currently.

Further, we are in the max tax bracket, so reducing our income with 401(k) contributions is appealing.

Finally, we have about $700K in after-tax accounts and $100K in Roth IRAs.

My current thoughts are to convert at least some of the 401(k)s to rollover IRAs, then to Roth IRAs over time after we retire and have lower income.

For now – are we better to continue to max the 401(k)s, or stop making 401(k) contributions and start making Roth 401(k) contributions (which will cost us 37% tax on $52,000 of extra taxable income), but may benefit us in the future?

Save Too Much Or Too Little In Your 401(k)

For starters, congratulations to them on accumulating a $2.5 million combined 401(k) balance at 50. According to my recommended 401(k) guide, this couple is doing extremely well.

If you are a younger saver (35 or younger), you can follow the younger saver guide. Between 35-50? You can follow the middle age guide. If you are 50 or older, then you can follow the older save guide.

The difference has to do with historical maximum 401(k) limits and returns.

Over the years, I’ve received so much pushback from younger folks who think my 401(k) by age recommendations are unreasonable. But as these younger readers grow older, they realize what’s possible with time, compounding returns, and company matches.

So for all you young guns out there who are simply making excuses for why you’re not there or why you don’t want to save more, please get your heads on straight. Otherwise, you might wake up 10 years from now bitter you have no options given your lack of funds.

Max Out Your 401(k)

Not maxing out your 401(k) is something I never thought about before because I always believe more is better up until at least the federal estate tax limit. Currently, the federal estate tax limit is $11.58 million per person. Therefore, there’s plenty of room for most people to keep on accumulating before they have to pay a 40% federal death tax.

It’s much better to retire with a little too much versus a little too little. The last thing you want to do in your 60s and 70s is to have to go back to work.

The thing is, you can’t save too much in your 401(k) because there is a maximum contribution limit each year. The maximum contribution limit in 2021 is $19,500. Expect the maximum contribution amount to go up $500 every two or three years.

Further, to achieve financial independence, everyone should be saving way more than $19,500 a year! Therefore, you can’t save too much in you 401(k).

Let’s hear a couple of great perspectives from two FS Forum members on this subject. Then I’ll conclude with my final thoughts.

Yes. You Can Save Too Much In Your 401(k)

Here’s a response from Money Ronin who believes you can save too much in your 401(k).

The answer is “yes, absolutely” although what counts as too much is dependent on your personal tax situation now and in the future.

The obvious downside is that you will eventually need to pay taxes and no one can predict future tax rates. Also, you will be forced to take a required minimum distribution (RMD) at 70-1/2 even if you don’t need the funds.

Finally, this is what really made me think twice about maxing out my 401(k) going forward. I met with a an estate planner. He mentioned everything I own gets a step-up in tax basis when I pass away, the 401(k) and traditional IRAs do not. 

If retirement plans are funded with pre-tax dollars, they are 100% taxable to my heirs once they start tapping into the funds.

The estate planner’s advice was that if I planned to bequeath anything to charity, bequeath the 401(k) first and avoid the taxation issues.  

Personally, I to spread the taxation risk by putting my money in various retirement accounts, IRAs, 401(k)s and Roth IRAs.

I’m not a tax or estate planning professional so hopefully other people can confirm or deny this information.

No. You Can Never Have Enough In Your 401(k)

Here’s another perspective from Fat Tony who says you can’t save too much in your 401(k).

Congrats on the great accumulation! I’m sure you know about the Roth IRA conversion ladder and all the associated calculators on the net.

If you plan to retire in five years, even given your current lopsided ratio of tax-deferred vs. tax-upfront savings, I would still make regular 401(k) contributions if you are in the 37% federal bracket. 

Your $700K after-tax investments are unly to generate too much income and you will ly be in a super-low tax bracket after retirement to do plenty of 22% and 24% bracket Roth IRA conversions (2% dividend yield on stocks = $35K/year mainly qualified dividend income).

Tax brackets aren’t slated to go up until 2026, although who knows what the future holds – it’s just unly that married taxpayers under $100/150K get a huge hike to above 37%, so you should be fine doing Roth conversions for a while and come out ahead if you defer the taxes.

Tax diversification is useful, but I think this close to retirement and at the max bracket the calculation is simple. What is the tax risk you’re willing to bear vs. the amount you are willing to pay upfront?

You can try to create a simulation with various tax bracket outcomes throughout retirement, although this is going to be an exercise in crystal ball-ism.

Related: The Disadvantages Of A Roth IRA: Not All Is What It Seems

Keep Contributing To The 401(k)

these two well thought out responses, the wise move is for this couple to continue maxing out their 401(k)s. In five years, their 401(k)s will be bolstered by at least another $190,000 of pre-tax contributions that would have been taxed $70,300 if they didn’t contribute.

Once they retire at age 55, they can simply live off their $700,000 in after-tax investment accounts until 59 1/2, when they can start withdrawing from their 401(k) penalty-free. $700,000 will only generate $28,000 a year in income at a 4% rate. Therefore, the couple would ly need to eat into principal.

Rule Of 55

Alternatively, the couple could follow the “Rule Of 55” if they do not want to wait until 59 1/2 to begin taking money their plans.

The Rule of 55 allows an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 1/2 to pull money his or her 401(k) or 403(b) plan without penalty. This applies to workers who leave their jobs at any time during or after the year of their 55th birthdays.

The Rule of 55 only applies to assets in your current 401(k) or 403(b)—the one you invested in while you were at the job you are considering leaving at age 55 or older. If you have money in a former 401(k) or 403(b), it’s not eligible for the early withdrawal penalty exemption.

Of course, if you’re smart and really need the money, you would simply combine your other 401(k) plans into your main plan before enacting the Rule of 55.

Rule 72(t)

Another strategy to consider is Rule 72(t), also known as as the Substantially Equal Periodic Payment or SEPP exemption.

To use this type of distribution rule, you would start by first calculating your life expectancy and then using that figure to calculate five substantially equal payments from a retirement plan for five years in a row before the age of 59 1/2.

The final strategy is to negotiate a severance in order to provide a financial runway into retirement. With $2.5 million in their combined 401(k)s, it is ly this couple has been with their respective employers for a significant amount of time. If there is no company pension, then they are prime candidates to receive a severance due to their years of loyalty.

If you are going to quit your job anyway at 55 with no pension, then you might as well attempt to negotiate a severance. A severance package usually equates to 1-3 weeks of pay per year for each year worked.

If the couple together earned $700,000 a year and worked at their jobs for 20 years, they could potentially receive 25 – 75 weeks worth of salary equal to $269,230 – $807,692 plus subsidized healthcare.

Build Passive Income As Well

Always max out your 401(k), especially if you are in a higher marginal income tax bracket. Take advantage of tax-deferred compounding and company matching. You have plenty of financial options before you face tapping your 401(k) early with a 10% penalty.

At the same time, build your taxable investment portfolio and rental property portfolio if you want to retire before the age of 59.5. The key to financial freedom is having a bevy of investments that produce passive income!

Below is a snapshot of my latest passive income investments. Rental properties and real estate crowdfunding are my favorite investments currently.

Analyze Your 401(k) For Excessive Fees

Stay on top of your 401(k) by signing up with Personal Capital. PC is a free online tool I’ve used since 2012 to help build wealth.

Personal Capital’s 401(k) Fee Analyzer tool is saving me over $1,700 a year in fees. Utilize the Investment Checkup feature to analyze your 401(k)’s asset allocation as well.

Finally, there is a fantastic Retirement Planning Calculator to help you manage your financial future. There is no rewind button in life. Leverage my favorite free financial too to build wealth!

Related post: How To Reduce Excess Fees In Your 401(k) Immediately

Readers, anybody feel strongly against maxing out their 401(k)? If so, why? For more top financial tools, check out my page. You can also sign up for my free newsletter here.


The Great Roth Controversy

Inherited a fat 401(k)? 4 things to know

This is your Money.  This is your Money on a Roth

I recently shared some thoughts on how to become Financially Independent in the shortest possible time by leveraging tax advantaged accounts such as the 401k, 403b, HSA, and Traditional IRA.  Taking advantage of all possible tax deductions Today is a great way to Turbocharge Your Savings, accelerating Financial Independence by years

I even made some disparaging remarks about the Roth IRA.  Some reader’s pushed back, which is always a good thing.

I will explain the reasons that I believe the Roth 401k and IRA are the least advantageous investment choices.  Furthermore, I will provide an overall recommendation for where to save for Financial Independence

First a brief comparison

Dollars saved in a Traditional 401k / IRA are pre-tax.  We pay no income tax on dollars going in, an immediate savings of up to 39.6%, the highest marginal rate.  The invested funds are allowed to grow tax free, so all interest, dividends, and capital gains are untaxed until withdrawn from the account.  Upon withdrawal, all funds are treated as ordinary income, similar to a paycheck.

Dollar saved in a Roth 401k / IRA are after-tax.  We pay normal income tax on any money put into a Roth, but this is the only tax that will ever be paid on those funds.  Any interest, dividends, and capital gains are tax free, forever

Ultimately the arguments for both types of accounts come down to one question:  Will your tax rate after retirement be higher or lower than it is today?

Let’s explore a few scenarios

Median Income

Let’s look at the median income earner, a family making ~$54k/year.  Because they are targeting early retirement, they are saving 50% of their after-tax income.  (I outlined the median income earner family in the post on how to Turbocharge Your Savings.)

They heard general advise that young people and those with low income can benefit from a Roth 401k, and they thought,  “That sounds us!”  Their highest marginal rate is “only 15%”, and some of the $17,500 savings would even be taxed at only 10%.  “Surely our post-retirement tax rate will be higher!”

With a $17,500 contribution to the Roth 401k rather than the Traditional 401k, the family would pay an additional $2,502 in tax, an effective tax rate of 14.3%. I’ll be generous and consider the 401k match of 2.7% ($1,444) as part of the contribution, lowering the effective tax rate to 13.2%

Fast forward 16 years to the point where they have achieved financial independence, and decided to quit their job and travel the world. Maybe they’ll even do something crazy, retire first then have kids.  Sounds a fine plan to me

Using constant 2014 dollars, how much would this family need to withdraw from the retirement account before paying the same tax rate of 13.2%?

$113,100! 5x their entire cost of living

Withdrawing their target spend of 50% of their after-tax working income, $22,700, they would pay an effective tax rate of 1%

Why the ROTH 401k Sucks for Early Retirement / Early Financial Independence

But wait, it gets better.  Remember that $2,502 that Mr and Mrs Median gave to Uncle Sam 16 years ago, instead of investing for their own use?  Had they invested those funds in their brokerage account as I recommended, their total savings would be 13% larger

Using the Roth 401k cost them.  They must either work longer, or be comfortable retiring with fewer assets

90% Percentile

What about somebody that earns a little more, perhaps at the 90th percentile of all US families?  With an income of $118k, this family is firmly in the 25% marginal tax bracket.

Being generous once again, counting the Roth 401k employer match as part of contributions, our example family elects to hand over $4,375 to Uncle Sam instead of investing for long term personal freedom.  They too targeted an early retirement budget of 50% of the working year income, a bit higher since they could afford a few luxurious due to their high earning power

How does this look come retirement time?

90% Percentile ROTH Situation

If they continue with their target spending of ~$48k, 50% of working years after-tax income, they will pay a tax rate of 6.9%.  And let’s not forget, had they chosen the Traditional 401k, those tax dollars would have been invested as well

That’s a substantial haircut off the 25% they chose to pay years earlier

To pay the same effective tax rate, they would have to make a serious effort to see how the 1% lives, withdrawing $385k in one year.  Kobe beef steaks and lobster tails on the yacht, anyone?

The Last Dollar Principle

In both examples, choosing a Roth 401k over a Traditional 401k resulted in less wealth and more tax.  Why?

Think about it this way.  When we invest $1 in a 401k, that dollar is the last dollar we earned.  It is taxed at our highest marginal rate.  But when we withdraw $1 from our 401k years from now, it is our First Dollar.  As we saw in the pretty pictures earlier, the First Dollar is always taxed at 0%

Now as spending increases to large levels, above ~$94k into the 25% marginal tax rate things get interesting.

This is where some start to argue about mathematics.  We could pull out our college algebra textbooks and prove beyond a shadow of the doubt that a Traditional 401k and a Roth 401k are EXACTLY THE SAME as long as the tax rate is the same.  This is true.  25% tax paid today is mathematically the same as 25% tax paid in the future after our funds have grown tax deferred

But math textbooks make simplifying assumptions which are often impractical in the real world (Hello quadratic equation, I’m talking to you.)

The odds of our Mr and Mrs 90% earning $94k in income from other sources (the lower edge of the 25% marginal rate), and every penny withdrawn from their 401k is taxed at 25% in the future is infinitesimally small

What matters the most is the aggregate tax rate, and for both of our examples this is lower than the marginal rate.

Pensions and Social Security

But there are other income sources.  I believe Social Security is here to stay, and we will certainly be able to access those funds in 30 or 40 years.

There are also a healthy number of people with pensions, although this is becoming less common

Above $44k in total income, 85% of Social Security is taxed as ordinary income.  100% of a pension is taxed at ordinary income

Both Social Security and Pensions are in proportion to working income.  In other words, the more you earned while working the greater the amount received from SS and a Pension

A typical federal government pension (a very generous program) will pay 1% per year of service, so someone with 30 years of service could replace about 1/3 of their salary.  A high earner that works until Age 65 could expect SS to replace about 26% of their salary.

For a federal pension and social security to pay $90k in taxable income a year, working year income would need to be greater than $185k.

As this is firmly in the 28% marginal tax rate, this family would also benefit by using a Traditional 401k

Required Minimum Distributions

Starting at Age 70.5, Uncle Sam will require that you withdraw funds from your IRA and 401k.  The amount is life expectancy, so the older you get the larger the minimum distribution.  See Jim Collins’ excellent post on this topic for more detail

How much $ would we need in a 401k for the RMD to have a punishing impact?  As we saw above in the case of Mr and Mrs 90%, a withdrawal of $385k has an effective tax rate of 25%

At Age 70.5, this equates to a 401k value of over $10.5 million

An individual that made maximum 401k contributions, with employer match, for 30 years could theoretically have this amount in their 401k.  All it requires is an annual return of about 16% for 30 years.  It’s not inconceivable, Warren Buffett did it

(If this is you, let’s blow this Popsicle stand and start a hedge fund)

When Is The Roth A Good Idea?

I’m glad you asked

The option to pay tax today and never again is of value, no doubt.  If you have an effective tax rate today of 0%, not uncommon for students and others in temporary low income situations, a Roth 401k or IRA is a great idea

It is also not a bad idea if you’ve already maxed out your Traditional 401k and have additional funds to invest.  When saving a high percentage of income, this SHOULD be the case.  Instead of putting an extra $5,500 into a brokerage account, you could put them in a Roth

For many, however, a brokerage account is just as good.  If during your retirement years you expect to earn less than ~$90k/year, staying below the 25% tax bracket, then all Long Term Capital Gains and Qualified Dividends are already taxed at 0%.  At these income levels, a brokerage account effectively has a 0% tax rate for stocks, much a Roth

The brokerage account also has the advantage of being able to harvest capital losses, and to spend dividends or gains anytime before Age 59.5


We have seen that for people with median income and above, taking advantage of the tax benefits of a Traditional 401k has long term tax advantages, allowing one to become Financially Independent in the shortest possible time

We also saw that the impact of Social Security, Pensions, and RMDs also favor the Traditional solutions over the Roth

In conclusion, the preferred investment vehicle is the 401k.  The HSA is also great.  Only when all other options have been exhausted does the Roth start to look interesting, except for families with poverty level incomes (ideally temporary)

For a rule of thumb, I would save funds into accounts in this order during the working years:

  1. 401k up to company match
  2. HSA
  3. 401k up to maximum
  4. Traditional IRA if tax deductible (subject to MAGI thresholds)
  5. Brokerage account
  6. Maybe $5k in a Roth (subject to MAGI thresholds)
  7. Maybe after-tax contributions to a 401k for Backdoor Roth (pros/cons)


Why a Roth last?  As can be seen in the comments, this is a contentious topic

What if you have already maxed out a 401k, an HSA, are not eligible for a deduction on a Traditional IRA, and have quite a bit of money remaining to be invested.  Isn’t putting $5,500 into a Roth better than putting those funds into a Brokerage account?


Because we aspire for a long retirement, our portfolio is stock heavy.  As explained in our classic post, Never Pay Taxes Again, taxes on Long Term Capital Gains and Qualified Dividends is 0% for incomes below ~$94k.

This is the same tax profile as a Roth, but with one distinct difference

We can spend those capital gains and dividends whenever we want, whereas the earnings in a Roth cannot be touched until Age 59.5 without facing a penalty and taxation (you can only access the Contributions)

Let’s look at that in numbers for Mr and Mrs 90%

Over a 13 year working career (faster due to using tax breaks of 401k), putting $5,500/year into a Roth IRA results in about $72k in contributions.  Using the FV function in Excel and a 7% annual return, when we retire early the account is worth about $110k.

If we had invested those funds in a Brokerage account instead, we would also have $110k.  Since Mr and Mrs 90% didn’t sell any of their stock they generated no capital gains.  And since they invested in their 401k reducing their marginal tax rate to 15%, they paid no tax on any of the dividends.

Of course with that stock being in a brokerage account, they have full use of the annual dividends.  At a 2% dividend rate on the S&P500, that is $2200 per year in cash flow for our use with zero tax

Fast forward 10 years, assuming the same annual growth rate, the account is now worth about $218k and continues to pay dividends (isn’t it great when the market only goes up?)  Speaking of the market going up, you can’t harvest capital loss in a Roth

Assume at this point we need access to $150k in future dollars to buy a large sailboat to fulfill our dream of sailing around the world.

If we had invested in a Roth and we try to access our Roth contributions at that point, we only have access to our original $72k investment.  We need more money

While full access to contributions is often cited as an advantage of a Roth, those contributions lose to inflation with each year.  While we can access our $72k in contributions, those funds are only worth about $53k in Jan 2015 dollars.  The earnings are much more valuable

Because we didn’t have access to the dividends in the Roth during our decade of joyful living, we’ve been spending down the Brokerage account a little faster.  Maybe we don’t have enough funds there to cover the difference

Now we need to either tap the Traditional 401k/IRA or the earnings in the Roth.  Both result in a 10% early withdrawal penalty and full tax on the withdrawal.  Such is the price of fulfilling our dreams

But what if instead we didn’t use the Roth years earlier?  We have $218k sitting there in our brokerage account, ready to use at our leisure without restriction.

And that is why the Roth is last, and why there is a big Maybe for all Roth contributions

(Post Early Retirement, creating a Roth IRA Conversion Ladder as part of our overall tax strategy, is a great practice to minimize long term taxes.  This is how we pay $0 in tax on our contributions and $0 on the withdrawals)


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