Do you pay taxes on an inherited IRA?

When you inherit an IRA or an employer-sponsored retirement plan, you must determine the taxes you will owe on the money. Usually, anyone can inherit an IRA- a spouse, child, brother, sister, parent, nephew, non-relative, or even an entity like an estate or trust. The tax rules for inherited IRAs, sometimes known as beneficiary IRAs, vary based on several factors.

The tax treatment of inherited IRA varies depending on the type of IRA, either a traditional IRA or a Roth IRA. Distributions from an inherited traditional IRA are taxable and are considered an income for the beneficiary that is subject to income taxes. However, if you inherited a Roth IRA, you can make tax-free qualified withdrawals at any time.

Inherited IRA rules

The IRS requires beneficiaries who inherit a traditional IRA or other retirement plan funded with pre-tax dollars to pay taxes on any withdrawals from the plan. Usually, this happens when the original IRA owner did not pay taxes on money deposited into the retirement plan or earnings generated over the years.

After inheriting an IRA, beneficiaries can choose to take a lump-sum distribution at any time, spread distributions over several years, or take required minimum distributions (RMDs) over their lifetime. The RMD is the minimum distribution that a beneficiary must take from the inherited IRA each year to avoid incurring a penalty.

RMD rules vary depending on the age of the original IRA owner at the time of death, the beneficiary's relationship with the deceased, and whether the deceased IRA owner took their RMD in the year of death. If the deceased IRA was taking RMDs and did not take the required distribution in the year of death, the beneficiary must take that RMD in the amount that the deceased would have taken in that year.

Are inherited IRAs taxed?

If you inherited an IRA, the distributions you take may be subject to income taxes depending on several factors. If you inherited a traditional IRA, any distributions you take will be treated as ordinary income, subject to income taxes. Traditional IRAs are usually funded with pre-tax dollars, meaning that the original IRA owner did not pay taxes at the time of contribution. Hence, any distributions from the inherited traditional IRA will be taxed at your tax bracket rate.

If you inherited a Roth IRA, you will be allowed to take tax-free distributions as long as the original account holder held the account for at least five years, including the period when the original account owner was alive. Roth IRAs are funded with post-tax dollars, meaning that the original IRA owner paid taxes on the contributions. If the inherited Roth IRA distributions don’t meet the qualified distribution criteria, they will be taxed as ordinary income.

Cashing out an inherited IRA

When you inherit an IRA, you can decide to cash out the inherited assets at any time. If you inherited a traditional IRA, the amount you cash out will be subject to income taxes and will be taxed as ordinary income.

Non-spouse beneficiaries are required to take a full distribution from the inherited IRA within 10 years of the original account owner’s death. In this case, you can choose to spread out distributions over the 10 years, and you will pay taxes on any distributions taken each year. If you choose to cash out the entire inherited IRA balance at once, the withdrawal will be added to your taxable income for the year, which could push you to a higher tax bracket.

If you cash out a Roth IRA, you won’t pay any taxes on the withdrawal as long as the money was in the account for at least five years, including the time when the original IRA owner was alive. Similar to a traditional IRA, non-spouse beneficiaries must take full distribution from the Roth IRA by the 10^th year of the original account owner’s death.

When you cash out an inherited IRA, you won’t owe an early withdrawal penalty even if you are below age 59 ½ at the time of withdrawal. Usually, early withdrawals from a traditional IRA are subject to a 10% early withdrawal penalty, but this rule does not apply to inherited IRAs.

Can you convert an inherited IRA to a Roth IRA?

Only a surviving spouse of a deceased IRA owner is allowed to convert an inherited IRA to a Roth IRA. Non-spouse beneficiaries are not allowed to roll over the inherited IRA assets and, hence cannot convert an inherited IRA to a Roth IRA.

As a spousal beneficiary, you can treat the inherited IRA as your own by transferring the inherited assets to your IRA, or by converting the inherited IRA into a Roth IRA. Be aware that you will pay income taxes on the inherited IRA assets you convert to a Roth IRA. You can also decide to convert the inherited IRA money to a Roth IRA over several years to spread the tax liability.

Converting an inherited IRA to a Roth IRA ensures that the retirement assets grow tax-free, and you won't owe income taxes on qualified Roth IRA distributions. Additionally, you won't be required to take RMDs when you reach RMD age.

How to minimize taxes on inherited IRAs

When making withdrawals from an inherited IRA, there are several strategies you can use to minimize the tax liability.

The first strategy is to avoid taking a lump sum distribution from the inherited IRA. Withdrawing the entire inherited IRA balance at once can push you to a higher tax bracket, and you will owe more taxes. Instead, you should spread the withdrawals over several years to keep the annual taxable income at manageable levels.

If you are a non-spouse beneficiary bound by the 10-year rule, you should plan withdrawals strategically to keep your taxes low. Instead of taking equal distributions each year, you can delay taking large distributions until in years when you anticipate a lower income. Similarly, avoid taking large distributions in years with significant incomes, since it can push you to a higher tax bracket.

If you are an eligible designated beneficiary such as a spouse, minor child, or disabled individual, you can spread distributions over your lifetime. You will be able to spread distributions over a longer period, hence reducing the annual tax burden. Also, as a surviving spouse, you can roll over the inherited IRA to your IRA, and delay taking distributions until you attain your Required Minimum Distributions (RMD) age.

If you are age 70 ½ and over, you can also choose to make a qualified charitable distribution (QCD) to an eligible charity. This option allows you to contribute up to $105,000 for individuals, and up to $210,000 for married couples. The distribution is excluded from your taxable income for the year, and it also counts towards your RMDs for the year.