Opening up an IRA can be somewhat confusing for some people. Knowing the ins and outs of tax and penalty implications for withdrawals and earnings is a bit more complex. Where it really begins to get complicated is when you inherit an IRA and have to deal with taxes.
The tax regulations governing inherited IRAs and IRA distributions can be confusing because they are very conditional. Navigating regulations to ensure that you pay the correct amount in taxes when you are supposed to pay them really requires the help of a seasoned tax professional who is familiar with your case. Here, though, you can find general guidelines on how the IRS views your IRA tax obligation should you inherit an account and its proceeds.
Your Options After You Inherit an IRA from Your Spouse
There are two general situations that you could face when it comes to inheriting IRAs. The first is when you inherit an IRA from your spouse. Most Americans who inherit an IRA get it from their husband or wife’s estate, making it the most common inheritance scenario out there (and one of the easiest to understand, thankfully).
You generally have three options when you inherit an IRA from a spouse. The first is to name yourself as the new account owner, which effectively transfers ownership of the account from your spouse to you. The second is to take the funds in the account and roll them over into an account you already have. The third option is to forgo ownership and claim yourself as a beneficiary of the account.
The first option subjects you to the same tax treatments as your spouse had. Any money in the traditional IRA is subject to tax when you withdraw it, and you can’t withdraw the funds until you turn 59 ½, generally speaking. The money will be taxed at your income rate, which means it could be considerably lower. Also, once you turn 70 ½, the funds can be withdrawn without taxes.
The second option – rolling over the funds into your account – means the money is treated just like the rest of your funds and isn’t taxed again if it was taxed when it was originally put into the account. If you inherit a Roth IRA, for example, the money your spouse put into that account won’t be taxed.
For beneficiaries, money is taxed when it is withdrawn at whatever marginal income tax rate you are in when you begin withdrawals.
Inheriting as a Non-Spouse Beneficiary
What if you are inheriting from a family member who wasn’t your spouse, say, your parents? In this situation, you can’t take ownership of the IRA, which limits your options. What you can do really is based off the distribution of the account.
At the age of 70 ½, traditional IRAs require their owners to begin required minimum distributions, which means you must take a certain amount of money out of the account every year from that date forward. If the person who owned the account has already began that distribution schedule, you’ll have to follow it. If they haven’t, then you can have the funds in the IRA distributed to you over a certain period of time based off your life expectancy. Or, you can roll the funds into what is called an inherited IRA which has to be completely withdrawn over 5 years. You’ll pay income tax on these distributions on your marginal income tax rate.
There are two tax implications in this case. First – and this is important – if the original owner of the account did not make a required minimum distribution in the year that he or she died, you must make the distribution yourself. Failure to take a required minimum distribution on time results in a hefty tax of 50% on the withdrawn funds – something you definitely want to avoid.
The second tax complication is that you’ll be entitled to an income tax deduction based on the estate taxes that were levied on the IRA. An IRA is subject to estate taxes, but to avoid double taxation, you can claim that amount on your taxes as a deduction and save yourself a good portion of money. You don’t have to be the one who paid the estate taxes, either.
Also keep in mind that you typically only get one chance to decide what you want to do with an inherited IRA; after that, it’s completely up to the IRS if you change your mind later. They’re under no obligation to honor your wishes then.
The Stretch IRA Option
Let’s look briefly at one of the options you have as a beneficiary: a stretch IRA. This is the life expectancy payout option described above. When you take these distributions over your lifetime, instead of five years (or all at once), you can allow these funds to grow without having to pay taxes on them for years and years, which is a huge advantage for many people and situations.
In other words, imagine paying taxes on $100,000 spread out over five years versus $100,000 spread out over 30 years. Plus, that $100,000 will have more time to grow.
Before you make any decision involving an inherited IRA, consult with an expert financial advisor who knows you and your situation. You generally only get one good shot at setting up your newfound wealth; professional help can ensure you get the most of it.