Taxability of Distributions
401(k) plans are tax-deferred accounts, meaning that money in such accounts have never been taxed. Therefore, when you take distributions from the 401(k) plan you've inherited, you are responsible for including the distributions on your income taxes. However, regardless of your age or the age of the decedent at death, the 10 percent additional tax to which non-qualified distributions are typically subjected to does not apply when you are a beneficiary of a 401(k).
Prior to the Pension Protection Act of 2006, non-spouse beneficiaries were not permitted to transfer money from an inherited 401(k) plan. With the passage of the Act, all beneficiaries are now permitted to do a direct transfer of plan assets to an IRA as long as the other plan is clearly identified as a beneficiary IRA. This is particularly useful if you want to leave the money in a tax-deferred account as long as possible. However, you are still required to take withdrawals annually, but these withdrawals are based on your life expectancy and you only pay taxes on the amount you withdraw each year.
The IRS has different rules for receiving distributions depending on whether the decedent was receiving distributions at death. If the decedent was already receiving distributions, the distributions must continue, at a minimum, at the rate they were occurring before death. If payments have not started, the beneficiary can choose between receiving the entire amount in no more than five years or annual payments based on her life expectancy. However, these are merely the IRS minimums for how quickly the money must be distributed. Companies can, and often do, set shorter required distribution periods. For example, a company could require a complete distribution of all remaining funds within 12 months of the decedent's death.
Special Spousal Treatment
As with most inherited retirement plans, a surviving spouse has additional options if named as the beneficiary. A surviving spouse can elect to defer required distributions from the inherited 401(k) plan until the year the surviving spouse reaches age 70 1/2. Essentially, the surviving spouse is permitted to treat the plan as if it is her own. However, the surviving spouse benefit does not apply when the decedent inherited the plan as a surviving spouse, later remarried and then died leaving the plan to his new spouse.