But because many retirees leave their IRAs and 401(k)s untouched as long as possible to avoid paying unnecessary taxes, you might someday face the bittersweet experience of inheriting a retirement account.
If that happens to you, you'll need to know how to avoid big pitfalls that could end up with the IRS taking a huge chunk of that cash. Here are some quick tips that can help you make it through all the rules and regulations governing retirement accounts.
Being Married Matters
The first thing you need to do is to look at the named beneficiaries for the retirement account in question. Whether you're a sibling, child, grandchild, or family friend to the person who passed away, you'll be treated similarly to any other beneficiary.
Options for Everyone Else
Everyone except the surviving spouse has fewer options available to them, but they do have a few choices to make. The default rule is that beneficiaries must take out the entire balance of an inherited IRA by the end of the fifth year following the death of the original IRA account holder.
The problem with the five-year rule is that it can leave you with substantial tax liability. Remember, with a traditional IRA or 401(k), any money that you withdraw will be added to your taxable income for the year you receive it. But another option available to most beneficiaries lets you stretch out distributions over a longer period.
To use what's known as a Stretch IRA, you need to withdraw a certain amount of money from the inherited IRA every year, beginning with the year following the death of the original account holder. The amount is recalculated each year, based on IRS tables that help you figure your life expectancy and the value of the retirement account at the beginning of the year. By using this method, you'll have the flexibility to take distributions from the inherited retirement account over anywhere from 20 years for someone who's 65 years old to 40 years or more for someone in their early 40s or younger.
Keep in mind that even if you use the Stretch IRA method, you can always take more money out of your inherited IRA than the calculated amount. The calculations only specify the minimum withdrawal each year.
Get the Details Right
Perhaps the trickiest part of inheriting a retirement account is getting your financial institution to get the necessary paperwork done. For a spousal rollover, nothing could be simpler, as you'll simply end up with a new IRA in your own name without necessarily any reflection that it came from the deceased spouse.
For everyone else, though, you must be sure that you keep your inherited IRA money separate from your own personal retirement accounts. In fact, the account name for the inherited IRA should include the name of the original account holder and reflect the inherited nature of the account. For instance, your account might be titled something like "IRA for benefit of John Doe as beneficiary of Jane Doe." Because brokers don't handle these transactions all that frequently, make sure to follow up to ensure that they've set things up correctly.
It's never easy handling money matters after the death of a loved one. But by making sure you follow the IRS rules governing inherited retirement accounts, you'll avoid seeing hard-earned money go to the tax man rather than family. That's a legacy anyone would be proud of.
Motley Fool contributor Dan Caplinger always has fond memories of his mom when he writes about inherited IRAs. You can follow him on Twitter @DanCaplinger.