The Feds and inherited IRAs

The proposal originally made a couple of years ago by Sen. Max Baucus of Montana to severely restrict inherited IRAs has re-emerged in the bill currently under consideration to extend interest rates on Federally subsidized student loans. The bill passed by a vote of 51-49, which is not enough to overcome a filibuster under the Senate's rules. (See the recent article in Forbes magazine.)

What this means for IRA owners is that the Federal government is continuing to cast its covetous eyes on money that is being held in tax-free accounts.

Traditional IRAs are accounts created with before-tax money and in which the funds may grow tax-free until they are distributed, but when funds are distributed from an ordinary IRA to the owner (called the "participant"), they are taxed as ordinary income. Until that distribution takes place, the Federal government does not get any revenue from the account. That delay is what irks some of our lawmakers.

When the participant dies, assuming that he is not survived by a spouse, his designated beneficiary will begin to take required annual distributions based on his or her life expectancy, again as ordinary income. For a young beneficiary, this can result in a "stretch" over several decades, a very favorable result.

The Baucus proposal is to remove that favorable treatment in the hands of the beneficiary and instead require that the beneficiary take all funds from the account, as taxable income, within five years of the death of the participant.

We can expect that this proposal will continue to resurface from time to time. Ultimately, we may see some form of it adopted for large inherited IRAs, perhaps those with assets over $10 million or $5 million.