Are inherited IRAs taxable?” The brief response is that receiving an IRA typically does not result in an instant federal income-tax liability; however, taking money out of an inherited traditional IRA can be subject to taxation.
The exact results will vary based upon the type of IRA you hold, if there were any after-tax contributions made into that account, your relationship to the deceased owner of the IRA, and at what point in time you begin taking distributions from the account.
In addition to evaluating your current retirement savings, knowing the difference between an IRA vs 401(k) will assist in making clear what is unique about your retirement plan, and what are the specific requirements for using those types of accounts.
Are Inherited IRAs Taxable When You Withdraw Money?
Traditional Inherited IRAs
An inherited traditional IRA’s distributions will usually be considered part of your annual tax liability for the year in which they were received. In addition, the IRS considers all traditional IRA distributions as ordinary income and does not tax them as capital gains.
An exception to this rule applies if the person who established the account had made non-deductible IRA contributions. A portion of the account could then represent money that has been previously taxed. Typically, that portion will not be subject to additional taxes when it is distributed; however, a Form 8606 may be required in order to calculate the amount that is taxable.
Therefore, a single large withdrawal would result in a greater tax liability than numerous smaller scheduled withdrawals; this is due to the fact that the increased amount of taxable income could potentially move some of your taxable income into a higher tax bracket.
Inherited Roth IRAs
The rules for inheriting a Roth IRA are very different from the rules that apply to other types of inherited IRAs. All contributions to a Roth IRA are tax-free when you take them out. Most of the earnings on those contributions will be tax-free as long as you’ve met the Roth IRA’s five-year requirement.
If your account has not been open for at least five years, then a portion of any earnings distribution could be subject to tax.
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Does the 10-Year Rule Affect Taxes?
Beginning in 2020, most non-spousal beneficiaries of an IRA will have to completely withdraw all funds from the account by December 31st of the tenth year following the original owner’s death.
Annual RMDs are required to be taken from a traditional IRA each year the deceased traditional IRA owner would have reached their required beginning date, if they had lived. If the traditional IRA owner died prior to their required beginning date and the beneficiary falls under the 10-year rule, then the IRS typically does not mandate that the beneficiary take any distributions from the traditional IRA until the end of the tenth year.
As a result, when to withdraw your money from your retirement account becomes both a compliance decision and a planning decision.
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Do You Pay an Early-Withdrawal Penalty?
As a general rule, there isn’t. However, the IRS allows for an exception from the standard 10% additional tax on an IRA distribution to a beneficiary or estate due to the death of the IRA owner. Therefore, a beneficiary under age 59½ is usually able to receive distributions from his/her inherited IRA without the customary early-distribution penalty; however, standard income taxes will likely remain applicable.
Spouses Have Additional Choices
In most instances, a surviving spouse will have a greater amount of freedom regarding how they want to handle an inherited IRA compared to other types of beneficiaries. For example, if the surviving spouse chooses to do so, he/she can continue to hold the account as an inherited IRA, or the surviving spouse can elect to designate the account as his/her own personal IRA.
Most non-spouse beneficiaries do not have the option of rolling the inherited IRA into their own individual retirement account (IRA). However, if there is a valid trustee-to-trustee transfer of the funds, the funds will retain their “inherited” status.
Before withdrawing funds, verify the account type, the deceased’s date of death, if the deceased had attained his/her required beginning date (RBD), if there are any non-deductible contributions made by the deceased, your beneficiary status, as well as the deadline for making the required minimum distributions (RMDs).
The Bottom Line
So, are inherited IRAs taxable? Traditional inherited IRA distributions typically have federal tax consequences as ordinary income, but qualified inherited Roth IRA distributions can be made without any federal taxes being due. A person who inherits an IRA receives the IRA from someone else; therefore, there will be two separate tax events: the inheritance of the IRA and the subsequent distribution(s) from the inherited IRA.
Before you take a large amount of cash from your inherited IRA as a single payment, make sure to work with an experienced tax professional and an investment professional to coordinate how much money you want to withdraw.
Read more: how to calculate inherited IRA RMD
FAQs
Do you pay taxes immediately when you inherit an IRA?
Generally, simply becoming the beneficiary does not create federal income tax on the full IRA balance. Tax is usually triggered when taxable amounts are distributed from the inherited account.
How are inherited traditional IRA withdrawals taxed?
Taxable withdrawals are generally treated as ordinary income in the year received. If the IRA contains nondeductible contributions, part of each distribution may be tax-free.
Are inherited Roth IRA withdrawals taxable?
Most inherited Roth IRA withdrawals are tax-free once the applicable five-year requirement has been met. Earnings withdrawn before that requirement is satisfied may receive different tax treatment.
Is there a 10% penalty on inherited IRA withdrawals?
Generally, no. IRA distributions made to a beneficiary because of the owner’s death qualify for an exception from the usual 10% early-distribution tax.