18 August 2015
Inheritances are generally not taxable to the recipient. When due, estate taxes should be paid by the estate before the beneficiary receives the assets. An exception to this rule is with traditional Individual Retirement Arrangements (IRAs) when inherited by someone other than the spouse of the deceased. When a traditional IRA is inherited by a non-spouse the recipient must pay income taxes on it for the year they take a distribution of the money from the IRA.
Roth IRAs are different. If the inherited IRA is a Roth IRA then the money should be tax free for the beneficiary to withdraw at any time. (The exception would be if the Roth IRA was less than 5 years old when the original owner died.)
Given that spouses can inherit IRAs tax free, and Roth IRAs can also be inherited tax free, the rest of this post is about non-spouses inheriting traditional IRAs.
When a non-spouse inherits a traditional IRA there are some choices to be made - and those choices may have significant tax consequences. The beneficiary chooses whether to liquidate the IRA right away, or turn it into a "stretch IRA" by taking Required Minimum Distributions (RMDs) each year. The amount of the RMD each year is calculated using IRS actuarial tables for life expectancy on this handy worksheet.
If the decedent was over 70 1/2 when they died the beneficiary has a choice between taking the RMD based on their own age, or taking the RMD based on the decedent's age. The younger the person taking the RMD is, the lower the RMD they must take each year. Lower RMDs mean a longer stretch of the IRA. The chart below summarizes the options for the beneficiary. (I stipulated individuals because the rules are different if the beneficiary of the IRA is an estate or trust.)
The most tax efficient option is to stretch the distribution of the inherited IRA for as long as possible. Distributions from an inherited IRA are counted as income. Liquidating the IRA within 5 years triggers income taxes on the distributions in the year(s) they are received. If the IRA is sizable you may find yourself paying taxes in a higher tax bracket than you ordinarily pay. If your normal AGI is $50K and you take $100K out of an inherited IRA, your AGI will jump to $150K that year, resulting in a much higher tax bill. Additionally, you lose the tax-deferred growth opportunity of leaving the bulk of the money in the IRA. Liquidating an inherited IRA should only be done if you have an urgent need for the money.
If the Deceased was over 70 1/2 when they died and you elect to stretch the IRA by taking RMDs, you can choose to take RMDs based on your age or the age of the Deceased. The most tax efficient choice is to take RMDs based on the age of the younger person. If you were older than the Deceased when they died, then you would use the Deceased's age to calculate RMDs. Otherwise, use your own age.
If you intend to stretch the IRA and take RMDs, you are on the clock. If you fail to take an RMD before 31 December of the year following the year the person died, then you are forced to liquidate within 5 years.
I have prepared the taxes for a few people who had liquidated an inherited IRA and were shocked to discover they had given themselves a substantial tax bill as a result. The states with income taxes will also tax IRA distributions. Even military service members need to beware. Your home of record might not tax your military pay, but they may very well want a piece of that inherited IRA.
If you have questions the time to ask is before you select how you want to handle the inherited IRA. Once you have received the distribution it is generally too late.
