Inheriting a retirement account like a 401(k) or an IRA is more complicated tax-wise than if you’d been left a house or a set of golf clubs. Here’s a tip on how to use a “stretch out” to avoid being hit with a big tax bill.
Stretching it out
A stretch out is a plan to start taking small distributions from an inherited retirement account over a period of time. It allows a person who inherits a retirement account to avoid paying income tax on the entire amount right away. Taxpayers also benefit by keeping the account as a tax-advantaged investment vehicle that can grow over time.
Example: Dee Lee Beloved, 30 years old, inherits a $1 million IRA from her deceased uncle. If she were to take the whole amount in a lump sum, she would move into a higher tax bracket and pay 39.6 percent tax on most of her inheritance. Instead, she opts to stretch-out the IRA distributions over the next several decades, based on IRS life expectancy tables for her age. She thus receives smaller, more tax-efficient regular payments each year. She invests the balance of the account in mutual funds and hopes its value will grow over time.
Choose from two options
The IRS requires you to take full disbursement of an inherited retirement account within five years, unless you create a formal stretch-out plan to take small regular payments over an extended period. This gives you two stretch-out options:
- An informal, self-managed distribution strategy in which you empty the account within five years.
- A formal plan in which you maintain the account and take regular distributions over many years, based on IRS life expectancy tables.
Extra option for spouses
When spouses inherit retirement accounts, they are allowed to treat it as if it were theirs originally. That means they can continue making tax-advantaged contributions and can start withdrawing funds after reaching retirement age.
But younger spouses may want to consider converting accounts to stretch outs anyway. That’s because you can start taking distributions immediately, instead of waiting until age 59 ½ to withdraw funds penalty-free.
Stretch outs can be complicated, and some inherited accounts have special rules limiting the use of stretch outs. The best bet is to get professional assistance to help you create an optimal tax strategy when you receive an inheritance.
As always, feel free to pass this Tip along to friends, and reach out if you need help with your personal tax and finance situation.
651 Via Alondra Suite 715
Camarillo, CA 93012
This publication provides summary information regarding the subject matter at time of publishing. Please call with any questions on how this information may impact your situation. This material may not be published, rewritten or redistributed without permission, except as noted here. All rights reserved.