If You Inherit an IRA, Is It Taxable?
Understand the tax implications and distribution rules when inheriting a traditional or Roth IRA to make informed financial decisions.
Inheriting an Individual Retirement Account (IRA) can have a significant impact on your financial situation, making it essential to understand the related tax implications. Whether you inherit a Traditional or Roth IRA, each comes with unique rules and tax liabilities that require careful management.
Traditional IRA Tax Implications
When you inherit a Traditional IRA, any distributions you take are taxed as ordinary income. For example, if you’re in the 24% tax bracket, your withdrawals will be taxed at that rate. This is because Traditional IRA contributions are typically made with pre-tax dollars, making the entire withdrawal taxable.
The SECURE Act of 2019 introduced a 10-year withdrawal rule for most non-spouse beneficiaries. This means the entire account balance must be withdrawn within a decade of the original account holder’s death. For large IRAs, this can create substantial tax liabilities and potentially push beneficiaries into a higher tax bracket. Spreading withdrawals over the 10 years can help minimize this risk.
Spousal beneficiaries have more flexibility. They can treat the inherited IRA as their own, allowing them to defer required distributions until age 73 and benefit from continued tax-deferred growth.
Roth IRA Tax Implications
Roth IRAs, funded with after-tax dollars, allow beneficiaries to take qualified distributions tax-free. However, if the account hasn’t met the five-year holding period, the earnings portion of withdrawals may be taxable.
The 10-year withdrawal rule also applies to Roth IRAs. While there are no immediate tax consequences for beneficiaries, withdrawing the balance within this timeframe can affect long-term financial planning. Taking distributions gradually over the 10 years helps maximize the tax-free growth potential of the account.
Distribution Schedules for Beneficiaries
For IRAs inherited after January 1, 2020, the SECURE Act requires most non-spouse beneficiaries to fully distribute the account within 10 years. This applies to both Traditional and Roth IRAs, although the tax implications differ.
Beneficiaries should tailor their distribution schedules to their financial and tax situation. Spreading withdrawals evenly across the 10 years can prevent large spikes in taxable income. Certain eligible beneficiaries, such as minor children or disabled individuals, may qualify for extended withdrawal periods based on their life expectancy, reducing annual tax burdens.
Federal Tax Withholding Considerations
When taking distributions, beneficiaries can choose to withhold a portion for federal taxes. This helps cover expected tax liabilities and reduces the risk of a large tax bill. The decision to withhold depends on the beneficiary’s tax bracket and overall financial situation.
If distributions push you into a higher tax bracket, withholding at the higher rate can avoid underpayment penalties. Tools like the IRS Tax Withholding Estimator can help beneficiaries determine appropriate withholding amounts.
State Tax Factors
State tax laws also play a role in how inherited IRA distributions are taxed. States like Florida and Texas, which do not impose state income taxes, only subject withdrawals to federal taxation. In contrast, states such as California or New York may impose additional taxes.
The treatment of inherited IRA distributions varies by state. Some states tax the full amount as income, while others exclude portions of it. Consulting a tax professional or reviewing state-specific tax codes is critical for understanding your obligations.
Penalty Risks for Missed Withdrawals
Failing to take required withdrawals from inherited IRAs can result in steep penalties. The IRS imposes a 25% excise tax on missed Required Minimum Distributions (RMDs), which can be reduced to 10% if corrected promptly. Beneficiaries must stay on top of deadlines, particularly under the 10-year rule, to avoid these penalties.
For instance, missing a required $50,000 withdrawal from a $500,000 Traditional IRA could result in a $12,500 penalty. Setting reminders or working with a financial advisor can help ensure compliance. The IRS does offer a waiver process for missed RMD penalties if the failure was due to reasonable error and corrective actions are taken. Filing Form 5329 with a written explanation can help request penalty relief.