Inherited IRAs

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. These accounts have become a less attractive inheritance, because in 2019 Congress killed off the so-called stretch IRA, which allowed beneficiaries to draw down these accounts slowly over their lifetime. Instead, beneficiaries now typically have to empty retirement accounts within 10 years.

Under the new rules, spouses who inherit a retirement account can transfer the money into their own IRA, which allows them to postpone taking distributions until age 73. Meanwhile, almost everybody else will want to move the money into an inherited IRA, which they’ll then have to empty within 10 years. 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.

Three tips: First, while a 10-year withdrawal period is less attractive than the old rules, it still offers the chance for further tax-sheltered growth. That’s especially valuable if the money is in a Roth, because it’ll mean 10 additional years of tax-free gains. By contrast, beneficiaries of traditional IRAs may want to take partial withdrawals in each of the 10 years, because those withdrawals will be extra taxable income on top of whatever else they’re earning. Indeed, if the original owner of the traditional IRA had started taking required minimum distributions, the IRA’s beneficiaries are compelled to take withdrawals each year.

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 your 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.”

Next: End of the Stretch

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