Many California residents have or will inherit an individual retirement account. Currently, the law allows the holder of an IRA to receive taxable distributions over the course of his or her anticipated lifetime. However, that may change if a law proposed in the U.S. Senate gets passed, and Californians and others throughout the country may have to make new plans to ensure tax compliance.

Max Baucus, the U.S. Senate Finance Committee Chairman, has proposed to alter the law with regard to how inherited IRAs are taxed. The senator says that people have taken undue advantage of the law by giving tax-free benefits to younger beneficiaries. His proposal would stop the practice of accumulating tax-deferred gains within IRAs, meaning people who inherit IRAs would no longer be able to pay the associated taxes over the course of a remaining lifetime. Instead, the senator has proposed a five-year tax plan for IRA inheritances. The proposal, which is estimated to give the U.S. Treasury $4.6 billion over the next 10 years, would take effect for IRA owners who die in 2013 or thereafter.

Included in the proposal are some exceptions to the five-year rule. Spouses of IRA owners may not have to pay the taxes in full within five years. The same goes for beneficiaries whose age is within 10 years of that of the account holder, as for beneficiaries who are disabled or suffer long-term illness. Children would also not be subject to the five-year tax rule until they reach adulthood.

Californians who own or will inherit an IRA will want to be certain of how the tax proposal might affect their accounts. If the proposal is made into law, then tax planning for many California residents may change significantly, and, as usual, some creative thinking will be required to ensure that taxpayers’ assets are duly protected.

Source: Bloomberg, “Sen. Baucus Eyes Inherited IRAs for $4.6B,” Richard Rubin, Feb. 7, 2012