When someone dies with money remaining in an individual retirement account, the IRA passes to the designated beneficiary. If you inherit the IRA from your deceased spouse, you can choose to treat it as if you were always the owner. If so, it's now your account, and any distributions you take are taxed as though you took money out of your own IRA, not an inherited IRA. If you don't make the election, or you aren't the decedent's surviving spouse, your distributions may be taxed differently than if you took the withdrawals from an IRA you own.
Early Withdrawal Penalties
An exception to the early withdrawal penalty for IRAs allows a beneficiary, regardless of age, to take money out of the inherited IRA penalty-free. As a result, regardless of how much of the distribution is taxable, you won't pay the additional 10-percent early withdrawal tax. If you're the surviving spouse and you make the election to treat the IRA as your own, you're now the owner and so no longer a beneficiary. In that case, the beneficiary exception to the penalty doesn't apply after you make the election. Instead, you must wait until you're 59-1/2-years old to take qualified withdrawals, or must qualify for a different early withdrawal penalty exception.
Inherited Traditional IRAs
Distributions from traditional IRAs that are inherited are taxed the same way as if the decedent were taking the distributions. If you're the surviving spouse and you elect to treat the IRA as your own, the income taxes on the withdrawal are calculated the same way as for any other IRA. This typically means that you won't pay any taxes until you take withdrawals, but the entire distribution will be taxable when you do take money out. If the decedent made nondeductible contributions, that basis carries over to the beneficiary, so a portion of each distribution will be tax-free.
Calculating Tax-Free Portion
If you inherit a traditional IRA containing nondeductible contributions, each time you take a distribution, you must calculate the tax-free portion. To do so, calculate the portion of nondeductible contributions in the IRA relative to the IRA value at the time of the withdrawal. Say your IRA is worth $100,000 and contains $33,000 of nondeductible contributions: 33 percent of the withdrawal is tax-free. If you take out $10,000, $3,300 comes out tax-free, and then only $29,700 of nondeductible contributions remains in the account for your next distribution.
When you inherit a Roth IRA, the taxation depends on whether five years passed from Jan. 1 of the tax year the decedent made the first contribution. If so, you get all the money out tax-free. If not, you first withdraw all the contributions, which still come out tax-free because they were made with after-tax dollars. When you start withdrawing earnings, you are taxed on those distributions. For example, say the decedent opened the Roth IRA two years ago, and it contained $6,000 of contributions and $1,000 of earnings. The first $6,000 is tax-free, but the last $1,000 is taxable. If you are the surviving spouse and you elect to treat the IRA as your own, you must wait until the account has been open for five years, including the time the decedent owned it, and you must be either 59-1/2-years old, permanently disabled, or taking out up to $10,000 for a first-time home purchase. Otherwise, you'll get the contributions out tax-free, but your earnings will be taxed and, unless an exception applies, penalized.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."