How to Reduce Tax on Inherited IRAs
If you inherit an individual retirement account, you won't face any immediate tax consequences. The act of inheriting an IRA in and of itself isn't a taxable event, according to the Internal Revenue Service. When you take money out, you may face tax consequences. In many cases, the IRS requires annual distributions from inherited IRAs, so you may have to deal with taxes every year. Certain situations allow you to sidestep any taxes.
You have the most flexibility in terms of reducing taxes if you are the spouse of a deceased IRA owner. As a spouse, you're entitled to treat the inherited IRA as your own. This allows you to roll over the inherited IRA into an existing IRA in your name, or to simply retitle the IRA in your own name. You can add money to it or roll it over to another account just as if you always owned the IRA.
For traditional IRAs, the IRS doesn't require you to begin taking annual withdrawals out of the IRA until April 1 of the year after you turn 70 1/2. However, if you inherit an IRA -- unless you are the spouse of the deceased -- you'll have to start required annual distributions sooner than that. One option is for you to take the entire amount out within five years of your inheritance. However, this won't minimize your taxes. If you're required to take distributions, your best option from a tax perspective is to take the smallest withdrawals you can. You can use tables provided by the IRS to calculate the minimum amount you must take out, based on your life expectancy and your year-end account balance.
Just because you are named as a beneficiary to an IRA doesn't mean you're forced to accept it. You can avoid taxes altogether on an inherited IRA if you disclaim it. When you disclaim an IRA, for legal purposes it's as if you died. The next beneficiary in line will inherit the IRA. You won't face any tax consequences for disclaiming your inherited IRA. However, you must act within nine months of the account owner's death. Otherwise, the IRA will legally pass to you.
If you inherit a Roth IRA, you can generally avoid all taxes and penalties. As long as the Roth has been open for at least five years, as a beneficiary you can withdraw money from the account without paying any taxes. While most Roth owners have to pay a 10 percent penalty for distributions before age 59 1/2, the penalty is waived for beneficiaries. You may have to pay tax on the earnings in the Roth -- not the contributions -- if the account has not been open for at least five years when you take your distribution.
- IRS: Publication 590: What if You Inherit an IRA?
- IRS: Publication 590: When Must You Withdraw Assets? (Required Minimum Distributions)
- IRS: Publication 590: IRA Beneficiaries
- Forbes: Five IRA Deadlines Every Smart Investor (or Advisor) Should Know
- IRS: Publication 590: Roth IRAs: Are Distributions Taxable?
- IRS: Publication 590: Roth IRAs: Additional Tax on Early Distributions
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.