The good news about being named the beneficiary to an inherited IRA is obvious: You came into money. The down side isn’t always so clear, though. But if you don’t mind your p's and q’s and follow the Internal Revenue Service’s rules about distribution from inherited IRAs to the letter, you might trigger unnecessary taxes and penalties that can take a big bite out of your inheritance.
Because money that goes into an IRA isn’t taxed, the IRS takes its share on money when it leaves it. This rule applies across the board with IRAs, so any distributions you take from an inherited IRA are treated the same as if you made a qualifying distribution from your own IRA. The IRS treats the distribution as ordinary income, and you pay your marginal rate on all distributions. This rule is unavoidable, so plan to give Uncle Sam his cut no matter how you distribute the cash.
If the IRA’s original owner was older than 70 1/2 when he died, the IRS required him to start taking required minimum distributions. If he hadn’t taken an RMD in the year he died, you must take it for him, but you can report the distribution on his taxes, rather than yours. After that, you may continue to take distributions based on the schedule determined by the owner’s projected lifespan, or you may develop your own RMD schedule based on your lifespan. You can also opt to take more than the RMD at any point, including immediately cashing out the IRA. Because funds in an inherited IRA grow free from taxes, if you choose the longer RMD schedule, your inheritance will have more time to grow free of taxes.
When you inherit an IRA from an owner who wasn’t 70 1/2 years old at the time of his death, you have a little more flexibility in how you choose to take the distribution. If you choose to cash out the account, the IRS gives you a five-year window to do so, which can help you spread taxes across several years and potentially prevent a single large distribution from bumping you into a higher tax bracket. If you want to maintain the tax-deferred status of the account, the IRS allows you to begin taking RMDs based on the IRS’s estimates of your lifespan.
If you inherit an IRA from your spouse, the IRS grants you more options when it comes time to decide how to deal with the funds. You have the same options as a non-spouse beneficiary depending upon the owner’s age at death, but you may also roll over the IRA’s balance into an IRA you own and then treat the account as if it’s your own. You may also choose to maintain the account as a beneficiary IRA. You’ll need to start taking RMDs the year your husband would have turned 70 1/2, based upon projections of his life expectancy.
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