“IRAs and 401(k)s were meant to supplement Social Security and pensions, but not provide a pool of money for heirs and other beneficiaries,” said Richard L. Kaplan, an expert on U.S. tax policy and retirement issues.

A new paper from a University of Illinois Urbana-Champaign expert on U.S. tax policy examines changes to inherited retirement accounts such as the 401(k) or the individual retirement account that could lead to hefty taxation issues for their new owners.

As the retirement accounts of the baby boom generation balloon in value, a 1986 law has allowed whatever’s left over in the account to be drawn down over the course of an heir’s lifetime.

But legislation enacted in late 2019 and regulations issued in early 2022 have sharply limited the flexibility that nonspousal beneficiaries now have regarding such assets and, by extension, the opportunity for families to create intergenerational wealth, says Richard L. Kaplan, the Guy Raymond Jones Chair in Law at Illinois.

“Congress enacted some little-noticed changes to longstanding tax laws that make certain retirement savings accounts much less appealing to inherit than they once were,” he said. “Nonspousal owners of inherited retirement accounts must now withdraw funds from these tax-protected investment vehicles over no more than 10 years, regardless of when these inherited accounts were first established.”

As a result, most nonspouse beneficiaries who inherit a relative’s IRA must take annual withdrawals that will likely push them into a higher tax bracket, thereby sharply curtailing the ability of inherited retirement accounts to create intergenerational wealth.

“Like Social Security and pensions, defined-contribution retirement plans and retirement savings accounts provide important income to finance the retirement of the worker and that person’s surviving spouse,” he said. “IRAs and 401(k)s were meant to supplement Social Security and pensions, but not provide a pool of money for heirs and other beneficiaries.”

The new law and regulations make that distinction real by significantly lessening the appeal of inherited retirement accounts and narrowing their best use to their original function – namely, providing retirement income to the worker and their surviving spouse, Kaplan said.

“At this point, if you have a retirement savings account with a healthy balance, you may want to reconsider your approach to managing these accounts and think more about using the funds during your lifetime,” he said. “Account holders may want to designate more money for charity, use those funds to purchase different, more tax-friendly assets or take out more than the minimum distribution. But the strategy to take the minimum so you can leave a significant inheritance to the next generation is much less appealing than before.”

The paper was published by the journal Virginia Tax Review.