My granddaughter's husband died last year. Before he passed away he withdrew money from his 401k. Does she qualify to claim the exemption for the 10%?

[Opus 17]

Because he withdrew money before he died, it will be reported on his tax return.   Of course, your GD is allowed to file a joint return for 2024 if she chooses, so the income is reported on their joint return.

You don't mention any specific exception he might qualify for.  Unfortunately, passing away after a withdrawal is not, by itself, an exception.  Exceptions to 401k withdrawals are listed here.

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-o...

Your GD now has an "inherited" 401k account, and she has a number of options.  Withdrawals she makes from the inherited account are probably excepted from the 10% penalty (they are for IRAs, I assume the rules for 401(k)s are the same but I haven't checked).   But withdrawals he made while he was alive are controlled by the rules that apply to him as the owner, not her as the heir. 

[NCperson]

@hannahcastellano15 sorry for your family's loss. 

There is an exception for a terminal illness.  See the "terminal illness" line in the link below.  The income tax is still due; it's the penalty that is waived if the exception is met. 

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-o...

inherited 401ks follow the same rules as inherited IRAs - they are not subject to the 10% penalty upon distribution.  if there is a decision to roll the inherited 401k to an IRA, be sure it's designated as an INHERITED IRA so that there is no 10% penalty on distributions. 

[VolvoGirl]

@NCperson   I think I'm in the same situation.  Why can't she as a spouse roll it over to her own IRA?  I haven't moved my husband's 401K, but I'm thinking about it.  My husband died in 2023 and was taking RMD.  They moved it to a spousal 401K under my name.   Even though I don't turn 73 until next year 2026,  I had to keep taking the 401K RMD based on my Single Life.  Other posts I read say you can roll it into my own IRA (not just Inherited IRA).   Why does it need to be a separate IRA?

[NCperson]

@VolvoGirl 

this is my understanding (and I do not prescribe to be an expert in this technical area)

spousal 401(K) beneficiaries have the option to

1) rollover to an IRA

2) maintain the account as an inherited 401(k) and take RMDs based on the beneficiary's life expectancy.

To answer your question, she can roll it over to an IRA, but that has consequences

The grandaughter's  choices 

a) granddaughter rolls $$$ to an IRA, then any distributions of those monies from the IRA will be subject to the 10% penalty until the granddaughter is 59.5 years old; there is no RMD until the grandaughter is 75 years old. 

b)  Granddaughter maintains the inherited 401k (or rolls to an inherited IRA).  Granddaughter must begin RMDs now based on her current age.  No 10% penalty on the RMD because it's an inherited 401(k) (or IRA).  There is no "10 year" rule because she is a spouse. 

For you, same thing.  There is no 10% penalty to worry about and it's the same life expectancy table whether there is an inherited 401k or an IRA.  Does the decision come down to the investment flexibility if the money is in the IRA versus the 401k and what the advisor fees would be if an IRA?  

so it does not need to be separate (and I have edited my post above as I was too emphatic), but if under 59.5 years old certainly there is an advantage to maintaining separate accounts.   

[Opus 17]

@NCperson 

@VolvoGirl  is correct, in the case of a spouse, there is a third option, to rollover the account into the spouse's IRA so it becomes the spouse's IRA instead of a separate inherited IRA.  I think your examples are a bit confusing.  There are 3 options.

1. Designate yourself as the owner (i.e. spouse becomes the owner but keeps the account separate)

2. Rollover the IRA into the spouse's IRA or qualified workplace plan (i.e. combine the money)

3. Spouse treats herself as a beneficiary (keeps the account as an "inherited 401(k) or "inherited IRA" instead of assuming ownership). 

Under option 1 or 2, the spouse becomes the owner of the IRA, and if they make withdrawals before age 59-1/2, they are subject to the 10% penalty for early withdrawal.

If the spouse chooses option 3, then they have to follow these additional rules,

1. Take an RMD every year based on their life expectancy (or withdraw more if they choose), withdrawals are exempt from the 10% penalty or

2. Opt-in to the 10 year rule, meaning the entire account must be withdrawn and closed by the end of the tenth year after the owner's death, but no RMDs are required in the mean time (withdrawals are exempt from the penalty).

Based on advice from @dmertz , they suggest that spouses should not be in a hurry to make a decision, and that it is often better for the spouse to leave the IRA as inherited, rather than assuming ownership, so they make withdrawals without penalty.  However, each person's situation is unique, and each taxpayer may want to consult their own financial advisor.

See this old post, just adjust the dates for current year. 

https://ttlc.intuit.com/community/retirement/discussion/inheriting-spouse-s-ira-i-m-under-59-1-2-yea...