Understanding The Risks Involved in Inherited IRAs

Understanding The Risks Involved in Inherited IRAs

When you find yourself as the beneficiary of an Individual Retirement Account (IRA) and the IRA owner passes away, you are told that you have received a tax-free inheritance. Well, that's only partially correct. Under current tax law, the estate receipt is tax-exempt, but you should still be able to take distributions from the account, which may be taxable. The fees depend on the type of IRA involved and the relationship of the beneficiary with the deceased.

Inheriting an IRA: What Happens Next?

When you inherit an IRA, you can withdraw as much as you want from the account without penalty. However, it is important to know the potential implications of income tax when withdrawing money from an inherited IRA. Also, there are clear differences in the cash withdrawal rules, depending on whether you are the spouse of the deceased owner or a non-spouse IRA beneficiary.

Traditional IRA

There are several types of IRA. A traditional IRA provides for a tax deduction in the years when contributions are made to the account. In other words, the contribution amount serves to reduce the taxable income of the person during the fiscal year in which the contribution was made. You can also make tax-deductible contributions. IRAs also increase with deferred taxes, which means that profits and interest are not taxable over the years. However, when the fund is withdrawn during retirement, known as a distribution, the amounts are taxed based on the personal income tax rate in the year of the withdrawal.

If the money is withdrawn before age 59 and a half, the IRS imposes a 10% penalty, and the distribution will be taxed at the owner's income tax rate. If you happen to inherit a traditional IRA to which both non-deductible and deductible contributions are made; then part of each distribution is taxable.

Roth IRA

A Roth IRA does not offer an initial tax deduction like traditional IRAs, but Roth withdrawals are tax-exempt during retirement. If you inherit a Roth IRA, you are fully tax-exempt if the Roth IRA has been held for at least five years.

If you get distributions from the Roth IRA before the end of the five-year holding period, they will be tax-exempt to the extent that they represent a collection of contributions from the owner. However, any gain or interest on the amounts of the contribution is taxable. 


The IRS has set the least amount that must be withdrawn from an Individual Retirement Account each year. These mandatory withdrawals are called RMD. RMDs are designed to deplete the funds in the account so that accumulations do not last forever. RMDs apply to defined contribution plans, such as 401(k) and traditional IRAs. However, Roth IRAs do not require an RMD.

As a general rule, you should start distributions when you turn 72 (or 70½ if you turned 70½ before January 1, 2020). All withdrawals will be included in your taxable income, except any part that was previously taxed or can be received tax-free, as in the case of the Roth IRA. If you don't take RMD, you could be subject to a massive 50% penalty for the amount that should have been withdrawn but not distributed.

The SECURE Act's 10-year rule

According to the SECURE Act, if a person was 70 and a half in 2019, they must have taken their first RMD before April 1, 2020. If a person is 70 and a half in 2020 or after, they can take their first RMD before April 1, of the year they clocked 72.

The SECURE Act has also changed when money is withdrawn from inherited IRAs and defined contribution plans. The SECURE Act requires the distribution or withdrawal of the entire IRA account to be withdrawn within ten years of the original owner's death. The ten-year rule applies notwithstanding if the participant dies before, during, or after the required beginning date, the age at which he should have started taking RMD, which is now 72½ years.

Simply put, you must withdraw the inherited funds within ten years and pay income tax for the amounts distributed. If you are under 59½, you will not pay the 10% fine, but you will have to pay income tax for the distributions. However, there are exemptions to the ten-year rule for a chronically ill person, surviving spouse, a disabled or a child who has not reached the age of majority, or a person who is at least ten years old years younger than the owner of the IRA account.

Special rules for surviving spouses

Spouses who inherit from an IRA have more flexibility than non-recipient spouses when withdrawing funds. The surviving spouse usually has a few options. The spouse can manage the IRA as their own IRA, designating the account holder or roll it over into their own IRA. They can also be treated as beneficiaries instead of managing the IRA as their own. 

The choice is normally based on when the spouse is ready to take their RMD or whether the deceased owner was taking their RMD at the time of death. The option chosen may affect the number of RMDs from the inherited funds and, therefore, may have tax implications for the beneficiary spouse.

Surviving spouse becomes an IRA owner.

If you are the surviving spouse and the sole beneficiary of the deceased spouse's IRA, you can choose to be treated as the IRA owner and not as the beneficiary. When choosing to be treated as the owner, determine the RMD as if you were the owner in the year you choose or if you are considered the owner.

Beneficiary spouses also have the option of transferring inherited IRA funds, or part of the funds, to their existing IRA. Spouses have sixty days from getting the inherited distribution to transfer it to the IRA, as long as the distribution is not an RMD. When combining funds, the spouse does not need to take an RMD before the age of 72.

Special IRA transfer rule

You can transfer up to $100,000 (a hundred thousand) from an IRA directly to a qualified charity. The transfer, known as a qualified charitable distribution (QCD), although no tax deduction is allowed, is tax-exempt and may include RMD (i.e., becomes tax-exempt). In other words, the transfer can gratify your RMD up to $ 100,000 per year and is not subject to value-added tax. 

Management of tax issues

When you get RMD from a traditional IRA, you will need to report income tax. You will receive Form 1099-R showing the value of the distribution. Next, you must report Form 1040 or 1040A for that year.

If the distribution is broad, it may be necessary to adjust the withholding tax or pay estimated taxes to account for the tax due on the RMDs. These distributions, known as one-time distributions, are subject to an automatic 10% withholding tax unless you elect not to withhold the deduction by completing Form W-4P.

Suppose the IRA owner died with a large property on which federal property taxes were paid, as the beneficiary you are qualified to a tax deduction for a portion of those taxes attributable to the IRA.

The federal tax deduction for a federal real estate tax return for a deceased person (like an IRA) is a very different deduction (you cannot claim it if you use the standard deduction instead of itemizing). However, you are not subject to the 2% limit of the AGI, which applies to most other miscellaneous itemized deductions.

However, check with the trustee of the IRA for the value and timing of your RMDs. Consult with an experienced tax advisor to ensure you comply with RMD requirements and applicable tax laws.



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