Whether you're hoping to have money left in your retirement accounts to leave to your loved ones or you've inherited a retirement account as a beneficiary, the big question is how much are you going to have to share with Uncle Sam. Unfortunately for anyone inheriting a retirement account, the distributions are still taxed in the same way they would have been for the original account holder.
Taxes on Distributions
Distributions taken by the beneficiary from the retirement account get taxed as if the money was taken out by the original owner -- there's no stepped-up basis for inherited retirement accounts. For tax-deferred accounts, that means that the beneficiary will have to include all distributions in her taxable income unless the owner made nondeductible contributions. For accounts that were funded with after-tax money, such as Roth IRAs, you get distributions out tax-free if the account has been open for at least five years when you take the distribution. If not, you still get the contributions out tax-free first, but then you must pay taxes on the earnings portion.
Estate Tax Deduction
If the estate's executor paid estate taxes on the retirement account, the beneficiaries qualify for an income tax deduction as they're taking distributions from the account. The deduction allows a write-off of the portion of the estate tax paid attributable to the money being withdrawn. For example, say you inherit an IRA worth $200,000 and the decedent's estate paid $80,000 of estate taxes because of the account. As you take withdrawals, you get to claim that $80,000 as in income tax deduction. For example, if you take out 20 percent of the account in the first year, you get a $16,000 deduction.
Early Withdrawal Penalty Exception
Beneficiaries of retirement accounts benefit from an exemption from the typical 10 percent early distribution penalty on withdrawals taken before turning 59 1/2 years old. No matter how old the decedent was at death or how old the beneficiary is when the distributions come out, the IRS waives the early withdrawal penalty. For example, if you're only 50 when you inherit your father's IRA, you can take the money out without paying additional penalties -- you must simply pay whatever income tax is due.
Though the money continues to grow tax-free as long as it stays in the retirement account, the funds can't remain in there forever. Instead, the IRS sets specific rules for how much money has to be taken out each year as a required minimum distribution. In some cases, beneficiaries might elect to distribute the entire account by the end of the fifth year after death. Spouses have additional options, which may include treating the retirement account as if it had always belonged to her. If the beneficiary doesn't take the required amounts out, the IRS imposes a 50 percent penalty.
- Internal Revenue Service: Publication 590 -- Individual Retirement Arrangements (IRAs)
- CNN Money: How the IRS Helps IRAs
- Internal Revenue Service: Topic 557 - Additional Tax on Early Distributions from Traditional and Roth IRAs
- Internal Revenue Service: Topic 558 - Additional Tax on Early Distributions from Retirement Plans, Other Than IRAs
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."