Most people no longer have to worry about their heirs paying estate taxes when they die; there is now a $5 million lifetime exemption from estate taxes ($10 million for a married couple). However people who have a lot of money in retirement accounts, have good reason to worry about their heirs having to pay income tax if they inherit those accounts.


When you pull money out of an IRA-type account (such as a traditional IRA, 401(k), SEP-IRA, 403(b), Simple IRA, or similar account), you have to pay income tax on the amount pulled out. When someone inherits that type of account, they likewise have to pay income tax. But how much they have to pay and when, depends very much on how the inheritance is handled.


For example, let us say I receive a letter one day from a bank, telling me that my rich uncle, who recently passed away, left me as the beneficiary of his 401(k) worth $200,000. The bank asks me to fill out their attached form, indicating what I want done with the account, and send it back to them. The form has a lot of confusing options, so I select what appears to be the simplest option, which is to cash it out and send me a check. Then when I get the check, I put it into my own account. However when tax time comes around, my accountant gives me the bad news. I must now pay income tax as if all of that money was ordinary income in that one year. Not only do I now have to pay the IRS $70,000 (assuming I was pushed into a 35% tax bracket as the result of the inheritance), but I may have lost various tax breaks that it would have otherwise been entitled to, because I am considered a high earner for that year.


What I should have done when I received the letter from the bank, is gone to my own preferred financial institution and established a beneficiary IRA. I could then have the bank pay the money directly into the new beneficiary IRA, and I would only have to draw out a small amount each year and pay tax on the amount drawn out. The rest of it would grow tax-free in the account. If I had a serious need, or a year in which I was in a lower-than-usual tax bracket, I could draw out more. To the extent I did not drawn it out, that initial inheritance might have grown into a very nice nest egg by the time I reached retirement age.

So what does this mean for a person who has a lot of money in an IRA-type account, in terms of their estate planning? For most people, it just means that they need to tell their heirs that if they ever inherit a retirement account, they should see a tax professional before signing anything. And then, those people can just designate their heirs as the death beneficiaries on the account. Unfortunately this does not work for some people, either because their heirs are minors, or severely disabled, or struggle with addictions, or perhaps are just too irresponsible to resist the temptation to start pulling all of the money out and spending it. For those people, an IRA Conduit Trust (sometimes called a “stretch IRA trust”) may be part of the planning.  IRA Conduit Trusts can be used for all IRA-type account.