What are the tax implications of an inheriting an IRA?
The answer depends on several factors:
- Is it a traditional IRA or a Roth IRA? The funds in a traditional IRA have never been taxed and will be taxed as they are withdrawn. Roth IRAs contain post-tax dollars and are not again taxed upon their withdrawal.
- Is the beneficiary of the IRA a spouse, a non-spouse person, or a charity?
When the beneficiary of an IRA is the spouse of the IRA owner, the spouse will have a number of options, depending on the spouse’s age. One option available only to the surviving spouse is the ability to simply roll the IRA over into his or her own IRA or a new one.
When a non-spouse beneficiary inherits an IRA, the rules are different. There are basically three options:
- Take a lump sum withdrawal. It is all then taxed as ordinary income when taken;
- Withdraw the money no later than December 31st of the fifth year after the death of the former owner. Taxes will be due as the funds are withdrawn; or
- Keep the account in an “inherited IRA” account. The balance will continue to grow tax-free, but the owner will have to make minimum annual withdrawal withdrawals based upon his or her life expectancy and cannot defer distributions until age 70 1/2.
While you cannot avoid the tax with a traditional IRA (unless given to a charity), it is possible to postpone it by selecting one of the deferred distribution options.
With a Roth IRA, the money went into the account after taxes, so the options are different. When spouses inherit, they again have the option of rolling it over into their own new IRA. Also, they can take a lump-sum distribution, but they should keep an eye on the calendar; the earnings will be taxable if the account is less than five years old.
Those who are not spouses have a better deal with a Roth than with a traditional IRA. A lump sum is still an option, although there will be taxes on earnings if the five-year mark hasn’t been hit. They can also use the life expectancy method — distributions come out tax-free (if the five-year holding period has been met); otherwise, only earnings are taxable.
These are just the basics, and there are be other options that can impact your choices. There are also modifications to these rules if an IRA has been left to be divided among multiple heirs.
The key takeaway here is to not make any immediate decisions after inheriting an IRA until all options are evaluated so you can make the best move for your situation.
A final note: A bill known as the “Secure Act” is presently being considered by Congress which, if passed (which seems likely), will make some significant changes to the way retirement accounts are administered and distributed. Keep tuned to this blog for future developments of this pending law.