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. But generally, the IRS taxes IRA distributions at your ordinary income tax rate, regardless if you inherited it or not.
The IRS taxes traditional IRA distributions at your marginal tax rate, while ROTH IRA distributions generally made with post-tax contributions are typically tax-free. However, if you inherited an IRA from someone who was older than 70 1/2 when he died and had not taken required minimum distributions, you have to take the distribution for him, but you can report this distribution on his taxes and not yours.
IRS Inherited IRA Rules
Because money that goes into a traditional IRA isn’t taxed, the IRS takes its share on money on the distributions. Generally, any distributions you take from an inherited IRA are treated the same as if you made a qualifying distribution from your own IRA.
However, Roth IRAs are treated differently, since you pay tax on money before putting it into the IRA and generally get any investment income tax free.
The IRS treats an IRA 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.
Required Minimum Distributions
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. Consult the IRS life expectancy table in IRS Publication 590-B for more information; the IRS Publication 590 series has information about IRA mechanics in general.
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.
Choosing Your Distributions
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.
Roth IRA Inheritance Rules
Since money in Roth IRAs is already taxed, the rules for inheriting such an account are a bit different than with a traditional IRA. Generally under IRS Roth IRA withdrawal rules, distributions from Roth IRAs are tax free provided the owner is at least 59 1/2 and has held the account for at least five years.
If you inherit a Roth IRA, you must either take minimum distributions over your lifetime, starting the year after the original owner died, or take all distributions by the end of the year containing the fifth anniversary of the original owner's death. Either way, any distributions taken after the original owner would have had the account open five years are tax free.
Depending on how long the account had been open, this may influence your choice of which distribution rule to use.
Recent Tax Law Changes
The rules around inherited IRAs aren't changing for the 2018 tax year (for taxes filed in 2019), but ordinary income tax rates are generally decreasing and tax brackets are generally getting wider, meaning a wider range of income included in each bracket. This may affect how you choose to take distributions from inherited IRAs.
For instance, for the 2018 and 2019 tax years, ordinary income tax rates range from 10% for the lowest wage earners to 37 percent for the highest, and are based on your income for the year.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.