Does Illinois Tax Inherited IRA Distributions?

Inherited Individual Retirement Accounts (IRAs) are financial assets passed from a deceased account holder to a designated recipient. These accounts allow for tax-deferred growth during the original owner’s lifetime. Upon the original owner’s death, the assets generally retain their tax-advantaged status, but distributions taken by the beneficiary may become subject to income taxation.

Illinois State Taxation Rules

Illinois does not impose a state-level income tax on distributions from inherited IRAs. The state’s tax laws exempt retirement income, including distributions from qualified plans and IRAs, from state income tax. While federal taxes may apply, the portion of the distribution attributable to Illinois income tax is not levied. Beneficiaries should report the distribution on their federal tax return and can deduct the amount on their Illinois state income tax return.

This exemption applies to both traditional and Roth IRA distributions. For traditional IRAs, the federally taxable portion is excluded from Illinois taxable income. Qualified Roth IRA distributions are tax-free at both federal and state levels. Beneficiaries should review Illinois Form IL-1040 for proper reporting of retirement income subtractions.

Federal Income Tax Treatment

Distributions from an inherited Traditional IRA are subject to federal income tax. These distributions are taxed as ordinary income to the beneficiary, similar to how they would have been taxed to the original owner. The amount included in the beneficiary’s gross income represents pre-tax contributions and earnings. If the original owner made tax-deductible contributions or the account grew through investment gains, those amounts become taxable upon distribution.

Conversely, qualified distributions from an inherited Roth IRA are free of federal income tax. This tax-free treatment applies if the Roth IRA has been open for at least five years, known as the five-year rule. The five-year period begins on January 1 of the year the original owner made their first contribution. Beneficiaries receive tax-free distributions if this holding period has been met, regardless of their own age or financial situation.

Non-qualified distributions from an inherited Roth IRA may include a taxable portion if the five-year rule was not met. In such cases, only the earnings portion of the distribution becomes taxable, while contributions are always tax-free. The Internal Revenue Service (IRS) provides guidance on determining the taxable portion of non-qualified Roth distributions. Proper record-keeping by the original owner can help beneficiaries distinguish between contributions and earnings.

Required Distribution Rules

The Internal Revenue Code establishes rules for when beneficiaries must take distributions from an inherited IRA. For most non-spouse beneficiaries where the original owner died after December 31, 2019, the entire account balance must be distributed by the end of the tenth calendar year following the owner’s death. This is known as the 10-year rule. There are no annual required distributions within this period; the beneficiary can take distributions at any time, provided the entire account is emptied by the deadline.

Failure to fully distribute the inherited IRA by the end of the 10-year period can result in a penalty. The IRS may impose an excise tax equal to 25% of the undistributed amount. This penalty can be reduced to 10% if the failure is corrected in a timely manner.

Certain beneficiaries, known as “eligible designated beneficiaries,” are exempt from the 10-year rule. These include surviving spouses, minor children of the original owner, disabled individuals, chronically ill individuals, and individuals not more than 10 years younger than the owner. These beneficiaries may stretch distributions over their own life expectancy, offering a longer period for tax deferral. Documentation, such as a physician’s certification, may be required to qualify for these exceptions.

Impact of Beneficiary Type

The type of beneficiary alters the distribution options and tax implications for an inherited IRA. A surviving spouse has the most flexibility. A spouse can choose to treat the inherited IRA as their own, often by rolling it over into an existing IRA or establishing a new one. This option allows the spouse to delay distributions until they reach their own RMD age, typically 73, and can continue to make contributions.

Alternatively, a surviving spouse can elect to remain a beneficiary of the inherited IRA, subject to RMD rules that may allow distributions over their life expectancy. This choice might be beneficial if the spouse needs immediate access to funds without penalty. The decision depends on the spouse’s age, financial needs, and overall retirement planning.

A non-spouse designated beneficiary, such as an adult child or a friend, is subject to the 10-year rule for distributions. This means they cannot stretch distributions over their lifetime, accelerating the tax implications for traditional IRA assets.

When an estate or a trust is named as the beneficiary, the distribution rules become more complex and less flexible. If the estate is the beneficiary, the IRA assets become part of the deceased’s probate estate and are distributed according to the will or state intestacy laws. If a trust is the beneficiary, the distribution rules depend on whether the trust qualifies as a “look-through” trust, which allows the oldest trust beneficiary’s life expectancy to be used for distribution purposes. Otherwise, more restrictive rules may apply.