Most people spend their working years asking how much they need to save for retirement. Once retirement begins, the question changes. Now they need to decide which assets to spend and which assets they would rather leave to their children.

For an American living in Israel, that decision can have a much bigger tax impact than most people realize. A retiree may have a traditional IRA or 401(k), a regular investment portfolio, cash, and real estate. All can fund retirement or pass to beneficiaries, but they do not receive the same tax treatment.

The usual advice is to preserve the IRA for as long as possible, especially since it grows tax free. For someone who made Aliyah, that advice may be backwards.

A traditional IRA or 401(k) can receive special Israeli tax treatment while it belongs to the person who earned it. That treatment generally does not transfer to the children. At the same time, appreciated investments may receive a major U.S. tax benefit when inherited that an IRA does not receive.

Instead of selling the regular investment account and preserving the pension, it may be better to gradually use the pension during retirement and preserve more of the appreciated investments for the beneficiaries.

Key Points

  • Qualifying foreign pension income is generally exempt from Israeli tax during a new oleh's first 10 years.
  • After the first 10 years, Section 9ג of the Israeli tax code may limit the Israeli tax on a qualifying U.S. pension.
  • The benefit under 9ג is connected to the person who earned the pension through work abroad. It generally does not transfer to a child who inherits the account.
  • A traditional IRA or 401(k) does not receive the normal U.S. step-up in basis that generally applies to appreciated investments inherited at death.
  • An inherited traditional retirement account generally remains taxable to the beneficiary and may have to be distributed within 10 years.
  • For many olim, it may make more sense to withdraw retirement funds during their own lifetime and preserve appreciated assets that may be more tax-efficient for their beneficiaries.

The Decision Retirees Have to Make

Imagine someone who made Aliyah many years ago and is now beginning retirement. They have $1 million in a traditional IRA and another $1 million in a regular brokerage account. The brokerage account contains stocks that were purchased for $300,000 and are now worth $1 million.

The retiree can take a distribution from the IRA or sell stocks from the brokerage account. Either choice creates cash, but the tax results are different. Selling the portfolio may cause some of its $700,000 of appreciation to become taxable at lower long-term capital gain rates.

Taking money from a traditional IRA or 401(k) generally creates ordinary taxable income for U.S. purposes, except to the extent that the account contains after-tax basis. Ordinary income tax rates can be higher than capital-gain rates, which is one reason advisers often tell retirees to preserve the IRA.

The missing part of the analysis is Israel.

An American retiree in Israel is not choosing between 2 accounts inside one tax system. The decision has to work under U.S. law, Israeli law, and the U.S.-Israel tax treaty. Once those rules are placed next to each other, the IRA may be more valuable in the parent's hands than it will ever be in the children's hands.

The First 10 Years After Aliyah

A person who becomes an Israeli resident for the first time, or who qualifies as a veteran returning resident, generally receives a 10-year Israeli exemption for qualifying foreign-source income under Section 14(a) of the Israeli Income Tax Ordinance.

During that period, qualifying distributions from a U.S. IRA or 401(k) may be exempt from Israeli income tax. The United States can still tax a U.S. citizen on the distribution because U.S. citizens remain subject to U.S. tax on worldwide income while living abroad. But Israel generally does not add another layer of income tax during the exemption period.

This does not mean everyone should empty an IRA during the first 10 years. A large distribution could push the taxpayer into a high U.S. bracket, and many olim are still working.

The favorable treatment also does not necessarily end when the initial exemption expires. That is where 9ג becomes important.

What Tesha Gimel Means

Section 9ג is commonly referred to in Israel as Tesha Gimel. It is one of the most valuable and least understood provisions for people who worked abroad before making Aliyah.

The rule says that Israeli tax on a qualifying foreign pension received because of the person's work abroad cannot exceed the tax that person would have paid on the pension had they remained a resident of the former country.

For someone who moved from the United States, the practical question is generally: How much U.S. tax would apply to this pension if the person had remained in the United States?

The calculation does not simply take the IRA distribution and stack it on top of every shekel of unrelated Israeli income. The foreign pension is measured against the tax treatment it would have received in the former country. Because the U.S. has a standard deduction and graduated brackets, the resulting ceiling can be much lower than the Israeli tax that would otherwise apply.

If a retiree takes a measured annual distribution, much of it may be absorbed by the U.S. standard deduction and lower brackets in the hypothetical calculation. Israel may therefore collect relatively little tax, even if the retiree has other Israeli income.

The wording of 9ג matters. It applies to a pension from abroad received because of the individual's work abroad. The benefit is connected to the person who performed the work and earned the pension. That personal connection becomes extremely important when the account is inherited.

How the U.S. and Israeli Taxes Work Together

Under the U.S.-Israel tax treaty, Israel generally has the primary right to tax a qualifying private pension received by an Israeli resident.

The United States does not disappear because the taxpayer is a U.S. citizen. The treaty generally allows the United States to continue taxing its citizens. However, the double-tax provisions can require the United States to allow a foreign tax credit for Israeli income tax paid on the pension.

In practice, Israel calculates its tax, taking the 9ג limitation into account when it applies. The pension is also reported on the U.S. return, and the taxpayer may claim a foreign tax credit for the Israeli tax attributable to that income.

Many Americans who worked in Israel paid more Israeli tax on their salaries than the U.S. tax due on the same income, creating foreign tax credit carryovers. These credits can generally be carried forward for up to 10 years and may help reduce U.S. tax on later pension distributions when the categories and sourcing rules align.

This is not automatic. The credits need to be in the correct Form 1116 category, and treaty resourcing has its own limitations. But when the pieces fit, a person may pay relatively low Israeli tax under 9ג, claim that tax as a credit in the United States, and use older credit carryovers to reduce some or all of the remaining U.S. tax.

That can make gradual IRA or 401(k) distributions surprisingly tax-efficient after retirement.

What a Step-Up in Basis Means

To understand which assets should be left to the children, we need to explain the U.S. step-up in basis.

Basis is generally the amount used to determine gain or loss when an asset is sold. If someone buys stock for $200,000 and later sells it for $1 million, the taxable gain is generally $800,000.

Now assume the owner holds the stock until death, when it is worth $1 million. Under the normal U.S. rule for inherited property, the beneficiary's basis is generally adjusted to the asset's fair market value at the date of death.

The child may now have a $1 million basis. If the stock is sold shortly afterward for $1 million, there may be little or no U.S. capital gain. The $800,000 of appreciation that accumulated during the parent's lifetime may never be subject to U.S. income tax.

Appreciated stocks, real estate, and other capital assets can therefore be excellent assets to leave to beneficiaries. The parent may face tax by selling during life, while the child may inherit little built-in U.S. gain.

There is an important Israeli complication. Israel does not always automatically recognize the same basis adjustment that applies in the United States. Depending on the facts, an Israeli resident inheriting foreign assets may need to seek a step-up or may retain some or all of the deceased owner's historic basis for Israeli purposes.

That issue must be reviewed. Still, the potential U.S. step-up is a major benefit that should be compared directly with an inherited traditional IRA.

Why an IRA Is Different

A traditional IRA or 401(k) does not receive the normal U.S. step-up that applies to appreciated capital assets.

The money generally represents income that has not yet been taxed. The owner may have deducted the contributions, and the investments grew without current U.S. tax. When a beneficiary withdraws money from an inherited traditional IRA, the taxable balance generally remains taxable income. The beneficiary inherits the account and the tax obligation inside it.

Most adult children who inherit an IRA are also subject to the 10-year distribution rule. The account generally must be emptied by the end of the 10th year after the owner's death. Depending on whether the original owner had begun required minimum distributions, annual distributions may also be required during that period.

This can force children to recognize substantial ordinary income during a short window, often in their highest-earning years. Instead of spreading distributions over a long retirement, they may need to add inherited IRA income on top of salary and other income. The account that was an excellent tax-deferred asset for the parent can become a compressed tax liability for the children.

Why the Children Generally Lose the 9ג Benefit

The Israeli side may make the inherited IRA even less attractive.

The parent's treatment under 9ג exists because the parent made Aliyah or returned to Israel and the pension came from the parent's work outside Israel. A child who inherits the IRA did not perform that work or make the original retirement contributions.

Even if the child is also a U.S. citizen and lives in Israel, the inherited account is not the child's pension from the child's own work abroad. The parent's personal 9ג limitation generally does not transfer with the account. The child may therefore face deferred U.S. income with no step-up, a 10-year distribution deadline, and Israeli tax without the parent's 9ג limitation.

A surviving spouse can have rollover and distribution options that are not available to an adult child, and foreign tax credits may still prevent some double taxation. But the main comparison remains. The traditional IRA can be unusually efficient for the original oleh to withdraw and much less efficient once it passes to the next generation.

Comparing the 2 Choices

Return to the retiree with a $1 million traditional IRA and a $1 million brokerage account containing $700,000 of appreciation.

If the retiree spends from the brokerage account, each sale may create capital-gains tax during life. The IRA remains untouched and eventually passes to the children. They do not receive a normal U.S. step-up inside the IRA. They inherit the taxable income, may lose the parent's 9ג treatment, and may have only 10 years to empty the account.

If the retiree instead takes gradual IRA distributions, the owner may be able to use 9ג, lower U.S. brackets, the treaty's foreign tax credit mechanism, and available foreign tax credit carryovers. The appreciated brokerage assets remain invested and may eventually pass to the children with a new U.S. basis at death.

The second strategy may not produce the smallest tax bill in every year. It may produce a much better result when the family is viewed as a whole. The goal should not be to minimize the parent's tax this year at any cost. The goal should be to minimize the combined U.S. and Israeli tax paid by the parent and beneficiaries over both generations.

This Does Not Mean Empty the IRA Tomorrow

The better strategy is usually gradual.

Taking an entire IRA in one year can create a high U.S. tax rate and waste the ability to spread income across multiple brackets. A better approach may be to model annual distributions based on the Israeli ceiling under 9ג, the owner's U.S. bracket, foreign tax credit carryovers, required minimum distributions, and actual cash needs. Expiring foreign tax credits may justify taking more income. Roth conversions may also be worth considering, with separate U.S. and Israeli analysis.

Roth IRAs should not be grouped with traditional retirement accounts. Qualified Roth distributions can generally be tax-free for U.S. purposes, including for beneficiaries, although inherited Roth accounts can still be subject to distribution deadlines. The argument in this article is strongest for traditional IRAs and 401(k)s containing deferred taxable income.

The Real Retirement Planning Question

Retirement planning and estate planning are often treated as separate conversations. Retirement planning asks how the parents will support themselves. Estate planning asks what the children will receive later. For an American living in Israel, those conversations need to happen together.

A traditional IRA may be valuable precisely because the original owner has personal tax benefits that the children will not receive. An appreciated investment may be painful for the parent to sell but valuable for the children to inherit because of the potential U.S. step-up.

The right question is not simply whether the IRA should be left to the children. It is which assets should be used while the owner's personal tax advantages still apply and which assets become more tax-efficient after they are inherited.

For many olim, the answer may be to gradually draw down traditional IRAs and 401(k)s during retirement while preserving more of the appreciated investment portfolio. That uses 9ג with the person who earned the pension and preserves the possibility of a U.S. step-up for the next generation.

If you need help modeling out the best options for retirement planning, and want experts who deal with it regularly, reach out.

Important Note: This is an article written by a human and shared on social media. The right answer depends on your accounts, tax history, family situation, beneficiaries, and long-term goals. I am happy to consult and advise based on your specific facts, but please do not treat this article itself as that advice.