People who leave an employer frequently leave their 401(k) behind. Usually, the wise thing to do is to roll that 401(k) into a rollover IRA. But with so many other things to do when changing jobs, deciding what to do with the old 401(k) is often low on the list of priorities.
But there is another way of leaving an employer other than changing jobs. Some people die while still employed. And here is where the issue can get tricky.
When funds are left in a 401k after death, those must be distributed to the benefactor chosen by the participant. The way they are distributed depends on the choices of the company administering the 401k along with personal choices of the benefactor.
There are two rules that apply to an after-death distribution. One of the two must be used in all cases. The first allows for payments to be made within 5 years of the death of the participant. The second option allows a benefactor to received payments through his or her lifetime on a regular basis. The company administering the 401k may limit the option it will provide. Or, the benefactor may choose the preferred option. In any case, the election must be made by December 31 in the year of the death of the participant.
If the surviving spouse is not aware of this rule and decides to leave the 401(k) with the employer, it’s entirely possible that he or she will receive a check for the entire amount of the 401(k) five years after death, minus 20% federal tax withholding. If the amount in the 401(k) is substantial the entire amount may be taxed. It is possible to roll the proceeds into an IRA if it’s done in time, but to avoid paying an income tax on the federal tax that was withheld, the amount of the tax has to be added to the rollover. This creates a very unpleasant surprise for the surviving spouse.