Transfer the Money to Your Own IRA
If you already have an IRA in place you could roll an inherited 401(k) into it with no tax penalty. The catch is that if you're under age 59 ½ when you execute the rollover, the withdrawal will be treated like a regular distribution.
In most cases (unless you are the surviving spouse), you can adhere to the 401(k)'s 10-year rule, which applies to 401k accounts that are inherited after 2020. This rule says that the account must be empty ten years after the date the account was inherited.
Some states have inheritance taxes, but California is not one. However, it's essential to be aware that even though there is no inheritance tax in California, there may still be federal estate tax to consider.
Ways to Avoid Taxes
The 401(k) rollover and the 401(k) loan are the two methods that you can use. Both have significant limitations, but they can potentially let you tap your 401(k) without paying taxes.
As a general rule, if you withdraw funds before age 59 ½, you'll trigger an IRS tax penalty of 10%. The good news is that there's a way to take your distributions a few years early without incurring this penalty. This is known as the rule of 55.
Generally, your deferred compensation (commonly referred to as elective contributions) isn't subject to income tax withholding at the time of deferral, and you don't report it as wages on Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors, because it isn't included in box 1 wages ...
Many people worry about the estate tax affecting the inheritance they pass along to their children, but it's not a reality most people will face. In 2025, the first $13,990,000 of an estate is exempt from federal estate taxes, up from $13,610,000 in 2024. Estate taxes are based on the size of the estate.
Answer: Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.
But when gains are inherited, the loophole zeroes out the gain for tax purposes. As a result, an investment sale that would create a taxable gain for the original owner is tax-free for the inheritor. Example: an investor buys 100 shares of stock for $200. Ten years later, the stock is worth $500.
While the beneficiary won't have to pay an early withdrawal penalty, the entire distribution amount is subject to income tax in the year it is received. This can push the recipient into a higher tax bracket. It's usually only a consideration when the beneficiary needs immediate access to the funds.
5-year rule: If a beneficiary is subject to the 5-year rule, They must empty account by the end of the 5th year following the year of the account holders' death. 2020 does not count when determining the 5 years. No withdrawals are required before the end of that 5th year.
As designated beneficiaries, most of these heirs will have two options for handling the inheritance: either transfer the assets to an inherited individual retirement account (IRA) or disclaim the account.
An inherited IRA may be taxable, depending on the type. If you inherit a Roth IRA, you're free of taxes. But with a traditional IRA, any amount you withdraw is subject to ordinary income taxes.
Yes. While creditors such as your bank typically cannot seize money from a retirement fund to settle outstanding bills, the same rules do not apply to the Internal Revenue Service. If you have outstanding taxes, the IRS may place a levy on your property in order to satisfy your tax obligation.
Key takeaways
If the account owner died after January 1, 2020, most non spouse beneficiaries must empty the account within 10 years following the account holder's death.
If you received a gift or inheritance, do not include it in your income. However, if the gift or inheritance later produces income, you will need to pay tax on that income. Example: You inherit and deposit cash that earns interest income. Include only the interest earned in your gross income, not the inherited cash.
If you're the beneficiary of a bare trust you are responsible for declaring and paying tax on its income. Do this on a Self Assessment tax return. If you do not usually send a tax return and need to, you must register for Self Assessment by 5 October following the tax year you had the income.
If you are the beneficiary of a life insurance policy and you owe the IRS, the IRS can seize those proceeds. Additionally, if you have a life insurance policy with no beneficiary named and you owe the IRS, the IRS can seize the policy funds before they are distributed to your next of kin.
Inheritance checks are generally not reported to the IRS unless they involve cash or cash equivalents exceeding $10,000. Banks and financial institutions are required to report such transactions using Form 8300. Most inheritances are paid by regular check, wire transfer, or other means that don't qualify for reporting.
When a house is transferred via inheritance, the value of the house is stepped up to its fair market value at the time it was transferred, according to the IRS. This means that a home purchased many years ago is valued at current market value for capital gains.
Gifting Money to Younger Children or Grandchildren. Gifting to younger children or grandchildren follows similar tax rules as gifting to adults. You can gift up to the annual exclusion amount per child ($18,000 in 2024) without triggering gift tax. For larger gifts, use the lifetime exemption and file IRS Form 709.
Traditional 401(k) withdrawals are taxed at the account owner's current income tax rate. Roth 401(k) withdrawals generally aren't taxable, provided the account was opened at least five years ago and the account owner is age 59½ or older.
Once you start withdrawing from your traditional 401(k), your withdrawals are usually taxed as ordinary taxable income. That said, you'll report the taxable part of your distribution directly on your Form 1040 for any tax year that you make a distribution.
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.