Stretch IRA

YOU MIGHT HAVE heard financial experts claim that IRAs, 401(k) plans and other retirement accounts are terrible assets to bequeath, because the government will end up with more than 80% of the money. This is just a scare tactic by financial advisors trying to drum up business: Unless you’re subject to federal estate taxes and the account’s beneficiaries are in the top income tax bracket, the tax bill will be considerably smaller.

Still, your beneficiaries will have to pay income taxes as they draw down the traditional retirement accounts you bequeath, and the accounts could become a less attractive inheritance—if Congress kills off the so-called stretch IRA. We’ll tackle that possibility in the next section. First, let’s look at the current rules.

Today, spouses who inherit a retirement account can transfer the money into their own IRA, which allows them to postpone taking distributions until age 70½. Meanwhile, everybody else should consider taking advantage of the stretch.

That means moving the money into an inherited IRA and beginning distributions in the year after the original IRA owner’s death. Spouses who are under age 59½ and need income right away might also choose this route, because it will allow them to avoid the 10% tax penalty on early withdrawals.

Each year’s required minimum withdrawal is based on the beneficiary’s life expectancy. That could mean a modest distribution. Meanwhile, the money remaining in the account can continue to grow tax-deferred. If handled correctly, an inherited IRA can provide beneficiaries with decades of tax-deferred growth, and that growth could more than compensate for a traditional retirement account’s embedded income tax bill.

Three tips: First, it’s crucial that beneficiaries follow the rules carefully—or they might disqualify themselves from using the stretch IRA strategy and, instead, be required to empty the account within five years. Second, check whether the original owner of the IRA made nondeductible contributions. If so, you won’t have to pay taxes on a portion of each year’s withdrawals. Third, if the IRA was part of an estate that was subject to federal estate taxes, you may be eligible for a tax deduction known as “income in respect of a decedent.”

Beneficiaries who inherit Roth IRAs will also need to take minimum distributions (unless you’re the spouse and choose to treat the Roth as your own). But in the case of the Roth, the annual distributions and the growth of the remaining money will be tax-free.

Next: No More Stretch?

Previous: State Estate Taxes

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