Don't Let Them Send You a Check. The '20% Withholding Trap' That Ruins Your Inheritance

Don't Let Them Send You a Check. The '20% Withholding Trap' That Ruins Your Inheritance

Losing a parent is emotionally devastating. Dealing with their finances afterwards is stressful. But if your parent left behind a 401(k) account, you need to be extremely careful before you sign any paperwork.

The HR department or the 401(k) administrator might casually ask: "Should we send the check to your home address?"

If you say "Yes," you just made a mistake that could instantly cost you 20% of your inheritance and trigger a massive tax bill that you cannot fix. Here is why the "Check in the Mail" is the most dangerous thing in estate planning.

Don't Let Them Send You a Check

1. The "Indirect Rollover" Disaster

When you move retirement money, there are two ways to do it:

• Direct Transfer (Trustee-to-Trustee): The money moves electronically from the 401(k) bank to your Inherited IRA bank. You never touch the money. (Safe)
• Indirect Rollover (Payout to You): The 401(k) plan writes a check in YOUR name. (Deadly for Non-Spouses)

The Trap: If the 401(k) plan administrator cuts a check to you, they are legally required to withhold 20% for federal taxes immediately.

Example: Mom left you $500,000.
If they send you a check, they only send $400,000. The IRS keeps $100,000 instantly.

2. The "Game Over" Mistake (No 60-Day Fix for Children)

You might think, "It's okay, I'll put the money into an Inherited IRA within 60 days to fix it."

STOP. You cannot do this.

While a surviving spouse has a 60-day window to fix mistakes, non-spouse beneficiaries (children, grandchildren) are legally prohibited from doing an "Indirect Rollover."

The moment that check is printed in your name:

• The tax-deferred status is broken forever.
• The entire $500,000 is treated as a taxable "Lump Sum Distribution" for 2026.
• You cannot deposit that check into an Inherited IRA. The IRS will reject it.

This is why you must never, ever accept a check directly.

3. 401(k) vs. Inherited IRA: Why You Must Move It

Many corporate 401(k) plans do not want to hold money for non-employees (beneficiaries). They often pressure you to take the cash.

If you take the lump sum, that $500,000 is added to your income. You will likely jump to the highest tax bracket (37%) and lose nearly half the money to taxes. To keep the money growing tax-deferred, you must move it to an "Inherited IRA" (Beneficiary IRA).

4. The Correct Strategy: "Trustee-to-Trustee"

Follow these exact steps to protect your legacy:

1. Do NOT accept a check: Tell the 401(k) provider clearly, "I need a direct Trustee-to-Trustee transfer to an Inherited IRA. Do not pay this to me."
2. Open an Inherited IRA First: Go to Vanguard, Fidelity, or Schwab and open an account specifically titled: "John Doe (Deceased), Inherited IRA FBO [Your Name]."
3. Initiate the Transfer: Have your new brokerage pull the funds directly. If the 401(k) provider must send a check, ensure it is made payable to "[Brokerage Name] FBO [Your Name]"—NOT to you personally.

Conclusion

Insurance companies and HR departments favor convenience over your tax savings. Sending a check is easy for them, but catastrophic for you.

Take control. Open the Inherited IRA first, and never let a check made payable to you touch your mailbox.

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FAQ: Inherited 401(k) Rules (2026 Update)

Q1. Can I combine the inherited 401(k) with my own IRA?
NO! Never mix inherited money with your own retirement money. It must go into a separate "Inherited IRA." Mixing them results in an immediate taxable event.

Q2. How fast do I have to withdraw the money?
Most non-spouse beneficiaries are subject to the "10-Year Rule." You must empty the account by the end of the 10th year after death.

Crucial Note: Under the IRS Final Regulations (effective 2025), if your parent had already started taking Required Minimum Distributions (RMDs) before they died, you must continue taking annual distributions in years 1-9 AND empty the account in year 10.

Q3. Does this apply if my spouse died?
No. Spouses have a special "Spousal Rollover" option where they can treat the 401(k) as their own. The strict "no indirect rollover" rule primarily targets non-spouse heirs.

Disclaimer: This article is for informational purposes only and does not constitute financial or legal advice. Tax laws involving inherited retirement accounts are complex. Always consult a CPA or estate planning attorney before moving funds.