How Your Inherited IRA is Taxed
Have you inherited an IRA? What type of IRA is it? Your answer will matter a lot when it comes to your tax bill. Inheriting a traditional IRA will have very different tax consequences than inheriting a Roth IRA.
Consider the following example. Let’s say Tom named his three children as beneficiaries of his three-million-dollar traditional IRA. He never made any nondeductible contributions. When his children take distributions from the inherited traditional IRA those distributions will be fully taxable, but not subject to penalty. What if Tom converted his traditional IRA to a Roth IRA more than five years ago? All distributions from the Roth IRA paid to his children would be tax and penalty free. That is a very different result.
If you were named the beneficiary of a traditional IRA, you will most likely face income tax consequences. This is because most funds in traditional IRAs are tax-deferred but not tax-free. Uncle Sam will eventually want his share. Distributions to beneficiaries will be taxable to the beneficiaries in the year taken. You can minimize the tax impact by using the stretch and taking distributions over the longest period of time the rules allow.
Are there ever times when a distribution from an inherited traditional IRA would not be taxed? Yes. The exception would be if there is any basis in the IRA. If so, that would be nontaxable and distributed in accordance with the pro-rata formula. How would there be basis in the account? This can happen in one of two ways. The deceased IRA owner either made nondeductible IRA contributions or rolled over after-tax funds from an employer plan during their lifetime. Any basis can be uncovered by reviewing the deceased IRA owner’s federal tax returns. They would have had to track their basis on Form 8606. That is the same form that you can use to claim basis when you take a distribution from an inherited IRA.
What if you are the named beneficiary of a Roth IRA? Roth IRAs work very differently. Tax-year contributions and converted funds are always tax-free when paid to beneficiaries. This makes sense because these funds are after-tax funds. The deceased Roth IRA owner has already paid taxes on them. Earnings will be tax-free if the five-year holding period that began with the deceased IRA owner’s first Roth IRA contribution is met. If not, earnings will be taxable until the five-year holding period has been satisfied. The good news for you is that earnings will not be considered distributed from the Roth IRA until all contributions and converted funds are paid out. The 10% early distribution penalty never applies to a distribution to either a traditional or Roth IRA beneficiary, regardless of their age or the age of the IRA owner.
The bottom line is that Roth IRAs are a great deal for a beneficiary. Most distributions will be income tax and penalty free.
If you inherit an IRA or Roth IRA through an estate or trust, the distribution rules will be different but the taxation of your distributions will remain the same.