How your inherited IRA is taxed depends on the type of IRA you inherit. Tax consequences are different for traditional and Roth IRAs.
Consider the following example. Let’s say Chris named his three children as beneficiaries of his three-million-dollar traditional IRA. He didn’t make any nondeductible contributions, so the entire account is pre-tax. When his children take distributions from the inherited traditional IRA, those distributions are fully taxable, but not subject to penalty. What if Chris 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. The outcome shifts from a “forever taxed” account to a “never taxed” account which is a big difference.
Named beneficiaries of traditional IRAs probably face income tax consequences. Beneficiary distributions are taxed the same year they’re taken, and at the highest tax bracket possible. You can minimize the tax impact by using a strategy called the “stretch” and taking distributions over the longest period of time the rules allow.
The exception is when an IRA has basis. Basis isn’t taxable. There are two ways basis can be in a traditional IRA:
- The deceased IRA owner made nondeductible IRA (after-tax) contributions.
- The deceased rolled over after-tax funds from an employer plan during their lifetime.
Reviewing for 8606 on the deceased IRA owner’s federal tax return can uncover basis. That’s the same form you can use to claim basis when you take a distribution from an inherited IRA.
Taxes are different for Roth IRA beneficiaries. Tax-year contributions and converted funds are always tax-free when paid to beneficiaries. The deceased Roth IRA owner has already paid taxes on them. There is a five-year holding period that begins when the deceased IRA owner makes his/her first contribution. Once met, earnings are tax free. Earnings are considered distributed when 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. So, you created a “never taxed” account for your beneficiaries.
The bottom line is that Roth IRAs are a great deal for a beneficiary. Most distributions will be income tax and penalty free.
Inheriting an IRA or Roth IRA through an estate or trust means distribution rules are different. However, taxation on your distributions are as mentioned above.