Tax Treatment for Inherited IRAs

Tax Treatment for Inherited IRAs

“Nothing can be said to be certain except death and taxes.” So said Benjamin Franklin.

Everyone is going to leave this earth some day and, yes, everyone will pay taxes – but, we can try to prolong facing these two guarantees as long as possible. Eat right, exercise daily, take care of your body – those are ways to prolong your life (of course we know that when God says we’re done, we are done – no matter how healthy).

A Stretch IRA is a way to prolong your tax payments when you receive an inherited IRA. So let’s take a look at the tax treatment of Inherited IRAs and what a Stretch IRA actually does.

Tax Treatment of Inherited IRAs

The big thing to remember is that you will have to pay income tax at your ordinary income tax rate when you take an IRA withdrawal from an inherited IRA – just like any other IRA.

The difference is that there are Inherited IRA Required Minimum Distributions that you need to be aware of. While you MUST start taking distributions, you have a choice in how you receive the funds. Usually, an inherited IRA must be completely liquidated within five years of the death of the IRA account owner, but there are additional options with this.

Inherited IRA Rules (from Spouse)

If you are receiving the IRA from your spouse, the IRS gives you the option to:

  • Treat the IRA as your own by naming yourself as the new account owner – no distribution and taxes dues (unless the spouse was already taking Required Minimum Distributions, then you must take distributions from the IRA.)
  • Treat the IRA as your own by rolling it into your existing IRA – no distribution and no taxes due.
  • Treat yourself as the beneficiary and start taking distributions – taxes due to the extent that whatever you pull out is considered ordinary income and taxed at your ordinary income tax rates.

Inherited IRA Rules (from Non-Spouse)

Let’s say Dad did a great job of saving up for retirement and Mom is no longer here. He’s named you as the beneficiary.

Now we get into the tricky part where an Inherited IRA actually comes in to play. If you are not the spouse of the existing IRA owner, there are a few different things to be aware of. You cannot treat the IRA as your own.

In other words, you must take something out! In fact, the entire account balance must be withdrawn by the end of the fifth year that you took over the account. The good news is that IRA beneficiaries are not subject to the 10% penalty even if they are under age 59 1/2.

Lump Sum Distribution

You can completely wipe out the IRA and take a full, lump-sum distribution. Of course, that money will be counted as ordinary income for the year.

So, for example, let’s say you are making $70,000 per year in income and you receive a $100,000 IRA as an inheritance. In your mind, you’d like to use retirement savings to pay off your debt, so you request a check.

Well, guess what – come April 15, Uncle Sam will be a very happy man!! That $100,000 IRA gets tacked on to your income for the year and it’s as if you just made $170,000 income!! That’ll be a tough check to write that year!

Stretch Your IRA Distributions

If the IRA account owner had already begun taking his or her Required Minimum Distribution, then the non-spouse beneficiary must continue taking out distributions at least at the same rate.

All distributions are subject to tax according to your ordinary income tax rate. If the IRA account owner had NOT already begun taking his or her RMD, then the IRA beneficiary has the option of “stretching” the distributions. What that means is the beneficiary can elect to receive distributions according to his or her own life expectancy instead of the deceased IRA owner’s life expectancy table.

This means you can take out much less each year and save a lot of money in taxes as well as allow the IRA account to hopefully grow tax-deferred, creating much more wealth down the road.

Refer to IRS Publication 590 for more detailed information on Inherited IRAs.




















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2 Comments
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  1. Hi Jason,

    Thank you for this article. I never quite understood inherited IRAs. One question, did you run across any information or different tax treatment if the owner passes on a Roth IRA? Stated in a different way, is there a different treatment if the funds for the inherited IRA come from a Roth IRA? It wouldn’t seem to make sense that the beneficiary of already taxed funds would have to turn around and pay taxes again through an inherited IRA. But when have taxes made sense?

    Any information would be greatly appreciated.

    Thanks,

    Cedric

  2. I disagree about being required to take out the IRA proceeds within 5 years if distribution has already begun.

    Owner Died On or After Required Beginning Date

    If the owner died on or after his or her required beginning date, and you are the designated beneficiary, you generally must base required minimum distributions for years after the year of the owner’s death on the longer of:

    *

    Your single life expectancy as shown on Table I, or
    *

    The owner’s life expectancy as determined under Death on or after required beginning date, under Beneficiary not an individual , later.

    http://www.irs.gov/publications/p590/ch01.html#en_US_publink1000230753

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