How are IRAs taxed at death?

If you are a named IRA beneficiary, you inherit IRA assets when the original IRA owner dies. Depending on your relationship with the deceased IRA owner, you have several options with the inherited IRA. There are potential tax consequences when you take distributions from the account.

IRAs are subject to federal and state taxes when the IRA owner dies. If you inherit a traditional IRA, you will pay ordinary income taxes on the withdrawals you take from the account. However, for a Roth IRA, you won’t pay income taxes on the withdrawals you make as long as they are qualified distributions. An IRA is also considered part of the deceased person’s estate and may be subject to estate taxes if the estate is big enough.

How inherited IRA works

If you have inherited an IRA account, you may have various options with the money. Depending on your relationship with the IRA owner, you can decide to keep the money in the inherited IRA, transfer the inherited assets to another retirement plan, or even take a distribution.

Most beneficiaries are required to deplete the inherited IRA by the 10th year after the date of the IRA owner’s death. The 10-year-rule applies to IRAs whose owners died after December 31, 2019. Different rules apply to IRAs whose owners died before December 31, 2020.

Generally, retirement assets held in the deceased individual’s IRA must be transferred to a new inherited IRA that is opened in the beneficiary’s name. Also, the beneficiary cannot make further contributions to the inherited IRA.

Estate taxes on Inherited IRA

If a non-spouse beneficiary inherited the IRA, the fair market value of the IRA would be added to the deceased IRA owner’s estate for estate taxes. The estate of the deceased owner would owe estate taxes if the cumulative value of all assets is more than the federal estate exemption for that period. As of 2022, the federal estate tax exemption is $12.06 million.

If a spouse of the deceased IRA owner inherited the IRA, he/she would be exempted from estate taxes based on the unlimited marital deductions provided under the federal tax code. However, when the surviving spouse dies, the full market value of the IRA would be included in their own estate for estate taxes if they were to transfer the assets into their account.

An exemption applies if the surviving spouse remarries and names their current spouse as a beneficiary. In this case, the unlimited marital deduction would apply again.

Tax Consequences of Surviving Spouse Inheriting IRA

Surviving spouses who inherit an IRA have more options with the money than non-spousal beneficiaries. The spouse can treat the inherited IRA as their own, roll over the inherited IRA into their own IRA, or continue as a beneficiary of the IRA.

The option that the spouse chooses is based on when they are due to start taking the required minimum distributions (RMDs), or if the deceased IRA owner was already taking RMDs at the time of the death. The distributions you take will be added to your taxable income for the year, and you will pay income taxes at your income tax bracket. If you decide to cash out the inherited IRA in full, the entire distribution will be included in your taxable income, which could bump you into a higher tax bracket.

Tax consequences of Non-Spouse Beneficiaries Inheriting IRA

Non-spouse beneficiaries do not have as many options with inherited IRAs as spousal beneficiaries. First, these beneficiaries cannot treat the inherited IRA as their own. Secondly, they cannot transfer the inherited retirement assets into their own IRA account. Instead, these beneficiaries must either cash out the entire distribution immediately or set up a new inherited IRA account.

If the IRA owner died after December 31, 2019, the SECURE Act requires non-spouse beneficiaries to take a full distribution by the 10^th year after the account owner’s death. You can withdraw any mounts and at any intervals, as long as you empty the account by the end of the 10 years. The withdrawals will be added to the taxable income for the year and taxed at your ordinary income tax rate. If the distributions occur in a year of high income, they could push you to a higher tax bracket.

Tax consequences of inheriting a Roth IRA

If you inherited a Roth IRA, you won’t owe income taxes on qualified withdrawals. For Roth IRA distributions to count as qualified, the Roth IRA owner must have held the account for at least five years. If the account was held for less than five years, any withdrawals from the account would be taxed as ordinary income.

If you are a surviving spouse of the deceased IRA owner, you can treat the inherited IRA as your own account, and make withdrawals based on your life expectancy. You won’t pay taxes on qualified Roth IRA withdrawals. However, if you are a non-spouse beneficiary, you would be required to deplete the inherited Roth IRA by the 10^th year of the account owner's death.

Can you delay paying taxes on an inherited IRA?

If you are a spouse of the deceased IRA owner, you can delay paying taxes on the inherited IRA by rolling over the funds into your IRA. Once you combine the funds, you won’t be required to take distributions from your IRA until you reach age 72, when you must start taking RMDs. This means you can delay paying income taxes until when you start taking the mandatory distributions.

If you are a non-spouse beneficiary, you are subject to the 10-year-rule unless you qualify for an exemption. You can choose to spread distributions over the 10-year period so that you pay taxes on the inherited assets over time. However, if you wait until the end of the 10-year-period, you will have a large distribution in a single year, which could push you to a higher tax bracket, and subsequently result in higher taxes on the entire distribution.

If you delay taking distributions past the 10 years, you could incur a 50% penalty on the remaining IRA balance.