Spousal Inherited Roth 401(K) Keep More Money Tax Free

There are differences in handling a spousal Inherited Roth 401(k) versus an inherited Traditional 401(k). When you have a Roth 401(K), you likely will need to address the Roth savings and the 401(k) savings and any associated matching and profit-sharing contributions which have different rules. I address the traditional savings in Contemplating Your Spousal Inherited 401(k) Options. It’s essential to understand the IRS rules and options to maximize the account’s current and retirement benefits. The spousal rules differ from the non-spouse ones, as they provide more options designed to foster your retirement income security. Here’s how to approach an inherited Roth 401(k).

Understanding Roth 401(k)s and Their Appeal

Roth 401(k)s combine the features of traditional 401(k)s (pre-tax) and Roth IRAs (post-tax). You essentially are inheriting two different accounts. The post-tax feature is technically called a designated Roth account (DRA) with after-tax dollar savings allowing for both tax-free growth and tax-free withdrawals, provided the account meets specific criteria. When inherited by a spouse, a designated Roth account retain these advantages but are subject to different IRS rules than the pre-tax savings of the Traditional401(k).

Designated Roth Account Before Age 59 ½ Withdrawal Treatment

There is no 10% early withdrawal penalty for the designated Roth Account. That is not necessarily the case for the traditional 401(k) and profit-sharing monies in the account. See my sister article to learn about the considerations.

The 5-Year Rule for Tax-Free Earnings

To withdraw earnings tax-free from a designated Roth account and/or Roth IRA:

1. The account must have been open for at least 5 years, and
2. The withdrawal must occur after age 59½ or meet another qualifying condition, like death or disability, which your inherited account, given its nature, does.

Key Spousal Inherited Roth 401(k) Options

The designated Roth account is made up of post income tax savings and the earnings on the account. Your spouse opted to pay the taxes on the contributions so that there would be no further taxation in the future. You now know that the Roth Accounts must be held for 5 years in order for the earnings to be tax free when withdrawn.

When inheriting a designated Roth account aka Roth 401(k) from your spouse, you typically have five options:

1. Cash Out the Account

o This option provides immediate access to the savings and the earnings but sacrifices tax-free growth potential.

o Designated Roth account taxation depends on whether the money inside the account is considered savings or earnings

1. Your spouses’ savings aka contributions are always tax-free when withdrawn.

2. Earnings withdrawn from a designated Roth account are only tax-free if your spouse’s account was open for at least 5 years.

o Traditional 401(K) money is fully taxed at your prevailing rate when withdrawn*. (*See at the end of the article for additional information regarding this option)

2. Maintain the account(s) as an Inherited Roth IRA and an Inherited IRA

o Set-up an inherited Roth IRA account for the designated Roth account (post-tax).

• Unlike traditional 401(k) money, designated Roth account (DRA) accounts are not subject to required minimum distributions. Monies withdrawn from the DRA before the account was held for 5 years, subjects the earnings (growth) portion to be taxed at your then prevailing income tax

o Set-up an inherited IRA for the 401(k) and profit-sharing money (pre-tax).

• Assuming that there are some pre-tax contributions aka 401(k) contributions, either made by your spouse or their employer, those monies are subject to required minimum distributions. See my article “Contemplating Your Spousal Inherited 401(k) Options” to learn more.

3. Roll the DRA Into Your Own Roth IRA or Current Employer’s Roth 401(k)

o Rolling the account into your name lets the funds continue to grow tax-free.

o Effect on the 5-Year Rule: If the spouse rolls the inherited designated Roth account into their own Roth IRA, the 5-year clock does not restart. Instead:

• The account is treated as if it had been owned by the spouse all along.
• The longer of the two timelines applies: either the original owner’s Roth IRA starting date or the inheriting spouse’s Roth IRA starting date.
• This means that if the inherited designated Roth account had already satisfied the 5-year rule, the funds rolled into your account would also be treated as satisfying the rule. If your own Roth IRA hasn’t yet met the 5-year rule, but the inherited account had, the inherited account’s timeline will count. You should discuss this with the custodian of your accounts to make sure they are able to reflect this in your account.

Example Scenario

• The deceased opened their Roth IRA in 2015 (meeting the 5-year rule as of 2020).
• The spouse inherits the Roth IRA in 2024 and rolls it into their own Roth IRA, which was opened in 2021.
• Since the inherited account satisfies the 5-year rule, any withdrawals of earnings from the combined account will generally be tax-free.

4. Roll 401(K) Into Your Own IRA or Employer 401(k)

o Check with the Plan Administrator to confirm that the workplace 401(k) plan accepts rollovers from inherited accounts.

o Request a direct rollover from the inherited 401(k) to the workplace 401(k) to avoid tax withholding or penalties.

o If rolling into the workplace plan, the funds will be treated as your own, and all future distributions will follow the rules for your personal account.

5. Leave it in Your Spouse’s Account at their Employer

o Depending on the size of your spouse’s designated Roth account, you may benefit from the creditor protection afforded by the Employee Retirement Income Security Act. ERISA, as it is known, has unlimited creditor protection whereas Roth IRAs do not.

o The availability of this option will likely depend on the rules inside of the plan document at their employer.

o Solo 401(k) or owner only 401(k) plans may provide the most flexibility, especially if there was a custom plan document.

Spousal Inherited Roth 401(k) Action Plan

1. Evaluate Your Goals: What do you want for your future? This should help with discussions with your financial team to see that your decisions are aligned with your objectives.
2. Consult a Designated Financial Professional: A team of a Certified Financial Planner, Certified Public Accountant, Enrolled Agent, Retirement Income Certified Professional should be helpful in navigating the rules. This account type is the most complex of those discussed in this series on tax advantaged, inherited retirement accounts. There are many gotchas that can unnecessarily cost ten or hundreds of thousands in penalties and taxes, not to mention tax-deferred and tax-free growth. As a spouse, you may also want to conserve as much of these accounts to be passed on to children and grandchildren.

Final Thoughts

A spousal inherited Roth 401(k) houses both a designated Roth account and a 401(k). This account offers unique opportunities for enhancing your lifetime income with tax-deferred and tax-free growth. By understanding the options and rules, you can maximize its value and align it with your long-term goals. Whether you’re planning retirement, building generational wealth, or securing your family’s future, strategic decisions can help you achieve lasting success.

Resources for More Information

IRS Guidance on Roth Accounts

*Surviving Spouse Taxation

A surviving spouse typically transitions from Married Filing Jointly (MFJ) to Single filing status according to the following timeline:

Year of the Spouse’s Death

• The surviving spouse can still file a joint return (MFJ) for the year in which their spouse passed away, if they did not remarry by the end of that tax year.

Qualifying Widow(er) Status

• For the two years following the spouse’s death, the surviving spouse may qualify for the Qualifying Widow(er) filing status, which allows them to:
• Use the same tax brackets and standard deduction as MFJ.
• Potentially reduce their tax liability compared to filing as Single.
• Eligibility Requirements for Qualifying Widow(er):
• The surviving spouse has not remarried.
• They have a dependent child who lives with them and for whom they provide more than half the support.
• They meet all other requirements for claiming the child as a dependent.

Transition to Single Filing

• If the surviving spouse does not qualify for the Qualifying Widow(er) status after the two years, or they no longer have a qualifying dependent, they must file as Single starting in the third year following the spouse’s death.