Pension death benefits are generally taxable to beneficiaries. Money coming out of an inherited traditional pension, 401(k), 403(b), or traditional IRA is treated as ordinary income to whoever receives it, because the original owner never paid tax on those pre-tax contributions or their earnings. Inherited Roth accounts are the main exception, and any portion of a pension funded with after-tax dollars comes back tax-free. How much you ultimately owe depends on the type of account, your relationship to the deceased, and how you time your withdrawals.
Why the IRS Taxes What You Inherit
Traditional retirement accounts hold money that was never taxed. Contributions went in before income tax applied, and earnings grew tax-deferred. When the account owner dies, that deferral doesn’t disappear with them. The tax code calls these funds “income in respect of a decedent” (IRD): income the deceased earned or was entitled to but never paid tax on. The beneficiary steps into that obligation.1Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
One detail catches many people off guard. Most inherited assets, such as a house or stocks held in a brokerage account, get their cost basis reset to fair market value on the date of death, which can wipe out capital gains tax when the beneficiary sells. Retirement accounts are specifically excluded from this step-up. The full value of an inherited traditional IRA or pension stays taxable.2Office of the Law Revision Counsel. 26 US Code 1014 – Basis of Property Acquired From a Decedent
How Much Tax You Owe by Account Type
Traditional Pensions, 401(k)s, and IRAs
Distributions from traditional pre-tax accounts are fully taxable as ordinary income in the year you receive them.3Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust Every dollar withdrawn gets added to your gross income and taxed at your marginal rate. A large account cleared out in a single year can push you into a bracket you’ve never been in before, which is the single biggest tax risk inherited accounts create.
If the original account included after-tax contributions, which was common in older employer pensions and in some 401(k) plans that allowed after-tax deposits, you get those contributions back tax-free. For annuity-style payments, the plan uses a fixed exclusion ratio to split each payment into a taxable portion and a tax-free return of basis.
Inherited Roth Accounts
Inherited Roth IRAs and Roth 401(k)s are the best-case scenario. Because Roth contributions were made with after-tax dollars, distributions of both contributions and earnings are generally tax-free. The one condition: the Roth account must have been open at least five years, counted from the start of the tax year of the original owner’s first contribution or conversion.4Internal Revenue Service. Retirement Topics – Beneficiary If the account is younger than five years, the contributions still come out tax-free but the earnings portion is taxable.
Tax-free distributions don’t mean you can leave the money alone forever. A non-spouse Roth beneficiary still generally has to empty the account within ten years. The withdrawals just won’t produce a tax bill.
Lump Sum or Annuity From a Pension
When the inheritance comes from an employer-sponsored defined benefit pension, you’re typically choosing between a lump-sum payout and a continuing survivor annuity. A lump sum means the entire pre-tax amount is taxable in the year you receive it, unless you roll it directly into an IRA or another qualified plan. An annuity spreads the tax over years or decades because each payment is taxed only as it arrives. Any after-tax contributions the deceased made to the pension come back as a tax-free portion of each annuity payment.
If You’re the Surviving Spouse
Surviving spouses have more options than any other beneficiary, and the choice you make controls when and how much you’ll owe.
Rolling the Account Into Your Own
You can roll inherited retirement funds into your own IRA or qualified plan through a direct trustee-to-trustee transfer. Once that’s done, the account is yours. Required minimum distributions don’t start until you reach your own RMD age (currently 73), and you can name your own beneficiaries.5Internal Revenue Service. Required Minimum Distributions for IRA Beneficiaries No other type of beneficiary can do this.
The trade-off: once you treat the account as your own, withdrawals before age 59½ are subject to the standard 10% early withdrawal penalty. A younger surviving spouse who may need access before 59½ should weigh this carefully.
Keeping It as an Inherited IRA
Keeping the account designated as an inherited IRA keeps distributions exempt from the 10% early withdrawal penalty regardless of your age.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions If your spouse died before reaching their required beginning date, you don’t have to start taking distributions until the year they would have reached RMD age.5Internal Revenue Service. Required Minimum Distributions for IRA Beneficiaries
You can also switch strategies. Starting with an inherited IRA for penalty-free access, then rolling the balance into your own IRA once you pass 59½, is a common sequence.
Avoid the 20% Withholding Trap
If you receive a distribution check from an employer-sponsored plan rather than completing a direct trustee-to-trustee transfer, the plan administrator must withhold 20% of the taxable amount for federal income tax. You can’t opt out.7Office of the Law Revision Counsel. 26 USC 3405 – Special Rules for Pensions, Annuities, and Certain Other Deferred Income You then have 60 days to deposit the full distribution (including replacing the withheld 20% from your own funds) into a qualifying account. Miss the deadline and the entire distribution becomes taxable. Arranging a direct rollover from the start is the only way to avoid the withholding entirely.
If You’re Not the Spouse: The 10-Year Rule
Adult children, siblings, friends, and most other non-spouse beneficiaries face a stricter timeline. The SECURE Act of 2019 ended the old “stretch IRA” strategy for most non-spouse beneficiaries and replaced it with a mandatory 10-year payout rule for deaths occurring on or after January 1, 2020.4Internal Revenue Service. Retirement Topics – Beneficiary
The entire inherited account balance must be distributed by December 31 of the tenth calendar year after the year the owner died. Within that window you have flexibility: take a little each year, wait until year ten, or anywhere in between. But the account must be empty by that final deadline.
There’s a trap the IRS didn’t fully clarify until 2024. If the original owner died on or after their required beginning date, meaning they had already started or were required to start taking RMDs, you must also take annual minimum distributions in years one through nine. The account still has to be emptied by year ten, but you can’t let it sit untouched in the meantime.8Internal Revenue Service. Notice 2024-35 – Certain Required Minimum Distributions for 2024 If the owner died before their required beginning date, no annual distributions are required and you just need to empty the account by the end of year ten. Figuring out which side of that line your deceased relative was on is one of the first things to pin down.
Who’s Exempt From the 10-Year Rule
A narrow group of non-spouse beneficiaries, called “eligible designated beneficiaries,” can still stretch distributions over their own life expectancy:4Internal Revenue Service. Retirement Topics – Beneficiary
- Minor children of the account owner, but only until they reach age 21. Once they turn 21, the 10-year clock starts on whatever balance remains.
- Disabled individuals whose disability meets the strict definition under Section 72(m)(7).
- Chronically ill individuals with physician certification of inability to perform daily living activities or a similar qualifying condition.
- Individuals not more than 10 years younger than the deceased, which covers siblings close in age and other near-age beneficiaries.
Eligible designated beneficiaries calculate their annual required distribution by dividing the inherited account balance by their single life expectancy factor, recalculated each year. For a young disabled beneficiary, this stretch can last decades and dramatically lower the tax rate on each year’s distribution.
Trusts and Estates Named as Beneficiary
If a trust is the beneficiary, it can qualify as a “see-through” trust only if it is valid under state law, becomes irrevocable at the owner’s death, and has identifiable individual beneficiaries. A qualifying trust is treated as if the individual beneficiaries inherited the account directly. If the trust doesn’t qualify, or if the estate itself is named, the fallback is harsher: the entire account generally must be distributed within five years if the owner died before their required beginning date.4Internal Revenue Service. Retirement Topics – Beneficiary
What a Missed Distribution Costs
The penalty for failing to take a required distribution on time is a 25% excise tax on the shortfall. SECURE Act 2.0 reduced this from the old 50% rate.9Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs A correction window exists: fix the missed distribution within two years and the excise tax drops to 10%. The penalty applies both to missed annual RMDs during the 10-year period and to any balance left in the account after the year-ten deadline.
Reporting and Withholding at Distribution
Every taxable distribution generates a Form 1099-R from the plan custodian. Box 1 shows the gross distribution, Box 2a shows the taxable amount, and Box 7 contains a distribution code. Death benefit distributions use Code 4.10Internal Revenue Service. Instructions for Forms 1099-R and 5498 You report the income on your personal Form 1040.
Withholding depends on where the distribution comes from. For inherited IRA distributions, federal income tax is withheld at a default rate of 10%, but you can elect no withholding or a different amount using Form W-4R.11Internal Revenue Service. Publication 590-B – Distributions From Individual Retirement Arrangements Distributions from employer-sponsored qualified plans that qualify as eligible rollover distributions face a mandatory 20% withholding rate that can’t be reduced or waived except through a direct trustee-to-trustee rollover.7Office of the Law Revision Counsel. 26 USC 3405 – Special Rules for Pensions, Annuities, and Certain Other Deferred Income
Low withholding plus a large distribution can leave you underpaid at filing time. Quarterly estimated tax payments may be necessary, especially in a year you liquidate a big account.
Ways to Reduce the Bill
If you’re subject to the 10-year rule, timing is your main lever. Spreading withdrawals across multiple years keeps each year’s taxable income lower than it would be if you waited until year ten and took one large distribution. Years when your other income is lower, such as a job change, partial retirement, or a gap year, are natural opportunities to pull more from the inherited account at a lower marginal rate.
If you inherit a 401(k) that holds appreciated employer stock, a strategy called net unrealized appreciation (NUA) may be available. You transfer the employer stock out of the plan into a regular taxable brokerage account. Ordinary income tax applies only to the stock’s original cost basis inside the plan; when you later sell the stock, the growth is taxed at the lower long-term capital gains rate instead of as ordinary income. The math doesn’t favor every situation, but for accounts with heavily appreciated employer stock the savings can be substantial.
If the inherited account was large enough to trigger federal estate tax, you can face a double hit: estate tax on the account value, then income tax when you withdraw. The tax code offers partial relief through the IRD deduction under Section 691(c).1Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents You can deduct the portion of federal estate tax attributable to the retirement account’s inclusion in the decedent’s gross estate, claimed on your income tax return in the same year you include the IRD in your gross income.12Internal Revenue Service. Revenue Ruling 2005-30 It won’t make you whole, but on a large inherited account it can meaningfully lower the effective tax rate.