Unlike other assets you receive from a decedent, distributions from an inherited individual retirement arrangement can increase your tax liability. Knowing how much will be taxable can alter your distribution plans when you are deciding how much to take out of your inherited IRA. For example, if your distribution will be taxable, you might take out more in years when you have less other income so it will be taxed at a lower rate.
Inherited IRA Basis
When you inherit an IRA, you assume the same basis for the account as the decedent. The basis is the amount of non-deductible contributions made to the account. For example, if you inherit a traditional IRA and the decedent did not make any after-tax contributions, you don't have any basis in the account. If you inherit a Roth IRA, your basis equals the amount the decedent contributed to the account because all Roth IRA contributions are after-tax.
Traditional IRA Distributions
When you take a distribution from an inherited traditional IRA, you have to prorate your distributions between your basis from the non-deductible contributions, if any, and the remainder of the account. For example, if the inherited traditional IRA has $30,000 in nondeductible contributions and a $100,000 total value, 30 percent of the distribution is tax-free and 70 percent is taxable. If the decedent didn't make any nondeductible contributions, your entire distribution is taxable.
The rules for distributions from inherited Roth IRAs differ from traditional IRAs. If the decedent had the Roth IRA for at least five years before death, all distributions from the account are tax-free. If the decedent had the account for less than five years, you can remove all the contributions tax-free, but the earnings are taxed upon withdrawal. For example, say your inherited Roth IRA was open for less than five years before the owner died and that it has $70,000 in contributions and a $30,000 in earnings. Your first $70,000 of distributions are tax-free and the last $30,000 are taxable.
Additional Tax Penalties
The IRS requires you to withdraw money from the inherited IRA unless you are the decedent's spouse and you treat the inherited IRA as if it were your own. If you don't take the required distributions, the IRS imposes a 50 percent tax penalty on the amount you should have taken out, even if the distribution wouldn't have been taxable. For example, if you are required to withdraw $9,000 but you don't take out any, you owe an extra $4,500 when you file your income taxes for the year.
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."