Inheriting a 401k from a relative who's died might seem like a curse when you realize that you'll have to pay taxes on the money, because the account was funded with pretax dollars. However, you won't have to pay the typical 10 percent penalty that the original owner would have been charged if he'd withdrawn the money early. Look at your options and determine whether you want the money now or would rather minimize your tax burden.
One option is to receive the entire amount in a lump sum. If this is your choice, the money will be added to your income at tax time and you'll have to pay taxes as though you'd earned the money. For example, if there is $500,000 in the account and you earn $50,000 at your regular job, you'll have to pay taxes on $550,000, minus your usual deductions.
If you want to reduce the amount of taxes you pay, you can spread your distributions out for the rest of your life. In this case, you would roll over the money from the 401k into an "inherited IRA." You wouldn't be able to add to the account, but you could still manage the investments. At this point, you'd be required to take a minimum distribution on a yearly basis, based on the number of years you would be expected to live. This smaller amount would be added to your yearly income, and your tax would be based on that.
Spouses have special privileges when it comes to inheriting an 401k. Though you can receive a lump sum or roll over the money into an inherited IRA and take minimum distributions based on life expectancy, you also have the option of rolling over the money into your personal IRA, treating the money as your own. This allows you to postpone making withdrawals and paying taxes, though you'd have to begin taking distributions once you turned 70 1/2.
When a single 401k account has two or more beneficiaries, the estate will divide the money up, opening separate inherited IRA accounts for each person. You are then able to make your own choices about how you treat the inherited IRA -- taking a lump sum or minimum required distributions -- and paying your own taxes, regardless of what the other beneficiaries decide.
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