The $750,000 401(k) Mistake That Quietly Costs Beneficiaries $120,000 in Excess Taxes

A 58-year-old posted on Reddit’s tax forum last fall that his father had left him a $750,000 401(k), and the plan administrator wanted to know within 30 days whether to cut a check, open an inherited IRA, or set up installments. He took the check, figuring the 10-year rule gave him plenty of time to deal with taxes later. That single keystroke set up a tax bill roughly $120,000 higher than the path he could have chosen instead.

This is the most common, and most expensive, mistake we see on inherited 401(k) balances in the $500,000 to $1 million range. The fix is mechanical, and the window to get it right closes on December 31 of the year after death.

What the 10-year rule actually requires

Since the SECURE Act took effect, almost every non-spouse adult child who inherits a 401(k) or traditional IRA from a parent who died in 2020 or later must empty the account by December 31 of the tenth year after death. If the parent had already started RMDs, the IRS requires annual distributions during years one through nine in addition to fully emptying the account by year ten.

The mistake is reading “10 years” as permission to cash out now or wait until year ten and pull everything at once. Both compress hundreds of thousands of dollars of ordinary income into a single tax year, where the bracket cascade does its damage.

How $750,000 becomes $120,000 in extra tax

Take a representative case: a married couple filing jointly with $200,000 in W-2 income, living in a state with a 6% top income tax rate. The inherited 401(k) is $750,000, and the decedent died in 2025.

Cash it out in year one and the household’s taxable income jumps to roughly $950,000. The inheritance pushes through the upper federal brackets, with the final slice spilling into the top bracket for joint filers in 2026 37% bracket that begins at $768,700. Federal tax attributable to the inheritance comes in near $240,000.

Spread the same $750,000 evenly across ten years and annual taxable income rises to $275,000, with the top dollar still in the 24% bracket. Federal tax across the decade attributable to those distributions totals roughly $178,000.

The federal gap alone is about $62,500. State income tax on a lump sum adds another $25,000 to $35,000 in higher-tax states. Two years of Medicare IRMAA surcharges, triggered by the two-year MAGI lookback when the beneficiary or spouse turns 65, can add $4,000 to $10,000 per person. The 3.8% Net Investment Income Tax on taxable-account gains in that year piles on more. The avoidable cost lands near $120,000.

Why the lump-sum path is hard to undo

Three details make this mistake sticky. A 401(k) cashed out to the beneficiary cannot be rolled back into an inherited IRA. The mandatory 20% federal withholding on plan distributions is only a deposit against tax owed; the beneficiary still reconciles the full bill at filing. IRMAA shows up two years after the income year, often long after the proceeds have been spent or reinvested.

The Vanguard 2025 distribution data shows the behavioral pattern: 29% of separating participants in 2024 took a cash lump sum, with cash-out rates running even higher for inherited balances handled outside an advisor relationship. The check is easy to ask for and almost impossible to take back.

Three moves before the December 31 deadline

1. Open an inherited IRA before any distribution is processed. A direct trustee-to-trustee transfer from the 401(k) preserves every distribution option, avoids the automatic 20% withholding, and starts the 10-year clock cleanly. Title the account exactly as the custodian requires, with the decedent’s name and your status as beneficiary.
2. Build a 10-year distribution schedule against your own bracket. If your household sits in the 22% or 24% bracket, fill those brackets each year and stop. Roughly equal annual withdrawals beat front-loading or back-loading in almost every case where future income is stable.
3. Confirm whether the decedent had started RMDs. If your parent was past age 73 and had taken even one RMD, you must take an annual RMD in years one through nine. Skipping a year triggers a 25% penalty on the missed amount, reduced to 10% if corrected within two years.

For balances above $500,000, a one-hour fee-only consult with a CPA or CFP to model the full 10-year drawdown against your projected income and IRMAA tiers pays for itself many times over.