By Mark Miller
Feb 14 Inherited retirement accounts are
truly one of those gifts that keep on giving because heirs can
benefit for many years without much tax burden, but Congress is
starting to talk about curtailing breaks on the accounts.
A revenue-raising proposal floated in the Senate Finance
Committee last week would sharply limit the time allowed for the
liquidation of inherited Individual Retirement Accounts (IRAs)
and 401(k)s. Currently, heirs can choose between taking a lump
sum distribution, or stretching out distributions over many
years. Heirs who do take the longer-range distributions from
these so-called "stretch IRAs" can, in turn, pass on the
accounts to their own beneficiaries, allowing the assets to
yield tax-sheltered returns for decades.
The Senate proposal would place a five-year limit on
retirement account liquidations. The change would help finance a
major transportation funding bill, raising $4.6 billion over 10
years by accelerating income tax due on assets coming out of
retirement accounts. And it would grandfather in existing
But it appears to be going nowhere fast right now.
The idea is worth considering, however, because it could
surface in future tax reform debates. The debate starts with a
valid point about tax policy: The idea behind preferential tax
treatment for IRAs and 401(k)s is to help people save for their
own retirement, not to make long-term tax-advantaged gifts to
Currently, the inheritor of a traditional or Roth IRA must
at least take a Required Minimum Distribution (RMD) each year as
defined by the Internal Revenue Service, starting the year after
the original owner's death. Beneficiaries younger than 59 ½ can
take distributions without incurring the usual 10 percent
federal early withdrawal tax penalty.
401(k) plan sponsors also can offer beneficiaries this
choice, although many only offer lump-sum distributions. In
those situations, an heir desiring long-term withdrawals would
simply roll the account over to a traditional or Roth IRA
outside the workplace plan.
In the case of a spousal heir, the inherited assets can be
rolled over into an IRA in his or her own name, which allows the
heir to delay RMDs until age 70½. Or, a widow can maintain the
account as an inherited IRA, in which case RMDs would need to
begin in the year following the death of the spouse - again,
without being subject to early withdrawal penalties. (In
situations where a younger spouse dies, the inheritor might want
to choose an inherited IRA, because the rules permit her to
delay taking RMDs until the date when the deceased spouse would
have been 70½).
For many heirs, a lump sum may sound attractive. But keep in
mind that retirement account distributions are taxed as ordinary
income upon withdrawal. The exception to this rule is an
inherited Roth IRA, which is funded with after-tax dollars
(inherited Roths are subject to the RMD rules).
A lump sum can generate a sizable one-time tax bill that has
unintended consequences, such as pushing the heir into a higher
tax bracket. For older heirs, a lump sum could also affect the
percent of Social Security income subject to taxation in a given
year, or trigger costly high-income Medicare premium surcharges.
"A Roth really is the ideal vehicle for an inherited IRA,"
says Christine Fahlund, senior financial planner at T. Rowe
Price. "The heir can stretch out the asset for decades
based on her life expectancy, and all the assets come out tax
free - the initial contribution and the returns on investment."
(Fahlund offers a caveat here: while Roth assets are free of
income tax, they are included as an asset for estate tax
RMDs are based on an IRS formula driven by the heir's life
expectancy; the RMD is calculated by dividing the account total
by the number of years the heir is expected to live. That means
RMDs are much smaller when the heir is young - but the
obligation must be managed carefully. Failure to comply results
in a 50 percent tax on whatever the RMD should have been for a
given year. (The life expectancy tables used to calculate RMDs
can be found in IRS Publication 590 ().
Stretch IRAs can generate impressive long-term returns,
because they continue to grow tax free. And, since most of the
funds won't be withdrawn for years, the assets can be invested
for aggressive returns.
T. Rowe Price offers this example, assuming a 7 percent
annual pre-tax return:
A man dies at age 70, passing on a $100,000 traditional IRA
to his 45-year-old daughter, who maintains it as an inherited
IRA and takes her first RMD in 2013. When she passes away at age
75, her son inherits the IRA at age 49, beginning his own RMDs
in 2043, and depleting the account fully in 2049. The daughter
would have enjoyed lifetime withdrawals of $256,951; passing on
$163,583 to the son. He, in turn, would benefit from lifetime
RMD withdrawals of $178,047.
Fahlund finds that clients with smaller account balances are
comforted to learn that even a modest gift to an heir can
generate that kind of long-range benefit.
"Many of our clients like the idea of passing along an IRA
to adult children who may not have saved enough for their own
retirement, or to help them pay college expenses for their
kids," she says.