What Happens to Your 401(k) and IRA When You Die? What Retirees Need to Know

Most people assume their will determines who will (or won't) inherit everything they own. That's true for many assets, but not retirement accounts. Your 401(k) and IRA generally pass according to the beneficiary designation on file with the financial institution, not the instructions in your will. Yes, that piece of paper you hurriedly filled out on your first day at work.

That piece of paper is powerful. It means an outdated beneficiary form could override years of careful estate planning. If your ex-spouse is still listed as beneficiary, or you never updated the paperwork after a death or remarriage, the original (non-updated) designee inherits the retirement plan. 

Understanding the process could help your family avoid unnecessary taxes, missed opportunities, and expensive mistakes.

Your beneficiary designation controls who inherits

Unlike many other assets, retirement accounts typically transfer directly to the named beneficiary without going through probate. The financial institution simply follows the beneficiary form it has on file.

If you've named multiple beneficiaries, each inherits the percentage you assigned. If no beneficiary is listed, or your named beneficiary dies before you and you didn't designate a backup, the account may instead become part of your estate.

This could create delays and reduce the tax-planning flexibility your heirs would otherwise have, which is why reviewing your beneficiary designations every few years is just as important as regularly updating your will.

A surviving spouse could roll the account into their own retirement plan

For many surviving spouses, the simplest and most flexible option is rolling the inherited account into their own IRA or employer retirement plan.

Once the rollover is complete, the money is treated as though it had always belonged to the surviving spouse. The account continues growing tax-deferred, and required minimum distributions (RMDs) generally don't begin until the surviving spouse reaches age 73 under current law.

This option also allows the spouse to continue managing the account under the familiar rules that apply to their own retirement savings plan rather than having to maneuver the special rules that govern inherited accounts.

An inherited IRA may be the better choice for younger spouses

Rolling the account into your own IRA isn't always the best answer. A surviving spouse also has the option to set up an inherited IRA instead. This could be particularly valuable if the surviving spouse is younger than age 59 1/2 and expects to need some of the money in the near future.

Withdrawals from your own retirement account before age 59 1/2 generally triggers a 10% early withdrawal penalty. Distributions from an inherited IRA owned by a surviving spouse generally avoid that penalty, giving younger widows and widowers greater flexibility while still allowing the remaining balance to continue tax-deferred growth.

The best choice depends on age, income needs, and overall retirement plans.

Taking the money all at once comes with a tax bill

Beneficiaries are generally allowed to withdraw the entire balance immediately. While that may sound appealing, taking your lump often comes with a significant downside.

For traditional IRAs and traditional 401(k)s, the entire distribution is generally treated as taxable income during the year it's received. A large inherited account could easily push someone into a much higher federal tax bracket and potentially affect other tax calculations as well.

Because of that, financial professionals often recommend evaluating other distribution strategies before cashing out the entire account.

Most non-spouse heirs now face a 10-year deadline

The rules are much different for adult children, siblings, friends, and most other non-spouse beneficiaries. Under the SECURE Act rules, most non-spouse beneficiaries must empty inherited retirement accounts by the end of the 10th year following the original owner's death. The old strategy of stretching distributions over the beneficiary's lifetime is no longer available for most heirs.

Inherited Roth IRAs are also generally subject to the same 10-year distribution period. However, qualified Roth withdrawals remain tax-free, making inherited Roth accounts substantially more valuable from a tax perspective than traditional retirement accounts. Required minimum distributions may continue during those 10 years

The 10-year rule doesn't always mean beneficiaries are able to simply wait until year 10 and withdraw everything. If the original account owner had already begun taking required minimum distributions before death, many non-spouse beneficiaries must also continue taking annual RMDs during years one through nine, then fully empty the account by the end of year 10. Missing those required distributions could lead to penalties, making it important for beneficiaries to understand exactly which rules apply to their inherited account.

Smart withdrawals could help reduce the tax bite

Many beneficiaries focus on meeting the 10-year deadline without thinking about taxes. That could be costly. Taking the entire account during a single high-income year may push someone into a higher tax bracket than necessary.

Instead, many beneficiaries are able to reduce the overall tax impact by spreading withdrawals across multiple years, particularly if they expect fluctuations in income or anticipate retiring during the 10-year distribution period. A little planning could potentially save thousands of dollars in taxes while still satisfying the IRS distribution requirements.

Bottom line

Two of the biggest retirement account mistakes happen long before anyone dies.

First, people forget to update beneficiary designations after major life events such as divorce, remarriage, or the death of a previously named beneficiary. Second, they never name a contingent (backup) beneficiary to inherit the account if the primary beneficiary dies first. Without a contingent beneficiary, the retirement account may end up passing to the estate instead of directly to an individual beneficiary. That could eliminate valuable distribution flexibility and create additional administrative headaches for your heirs.

Reviewing your beneficiary forms every few years takes only a few minutes, but it could help avoid surprising financial mistakes, spare your family unnecessary taxes and confusion during an already challenging time.