What are the tax consequences when you inherit an Individual Retirement Account? You may think the inheritance is income tax-free. However, amounts you withdraw can be taxable — in some cases, even when you inherit a Roth IRA.
For example, say you’re the beneficiary of a Roth that has been open for less than five years. In that case, you’ll pay federal income tax on account earnings when you withdraw them. Withdrawals of contributions remain tax-free.
What if you decide not to take distributions? Unless you are the spouse of the original owner, you’re required to take minimum distributions from an inherited Roth — and there’s a penalty for failing to do so.
As you may know, the required distribution rules also apply to inherited traditional IRAs, and distributions you take are taxable as ordinary income. Here’s a potential tax-saving tip you may not be aware of: Determine whether the original owner made nondeductible contributions or had other basis in the account. Those amounts are inherited with the traditional IRA and reduce the taxable portion of distributions.
The age of the person from whom you inherit also affects required distributions. When you’re the beneficiary of a traditional IRA owned by someone age 70½ or older, you’ll have to withdraw the annual distribution required of the original owner in the year of death. The distribution is taxable to you.
Depending on your situation, you may have some options regarding the timing of required distributions from inherited IRAs. Please contact us if you would like more information.