If you inherit an Individual Retirement Account (IRA) from someone other than your spouse, you should be aware of the rules attached to that account to help avoid any negative tax consequences. While the account legally belongs to you and you have the right to do whatever you'd like with the money, a little knowledge about how inherited IRAs work can save you some grief, and perhaps even some money.
An Individual Retirement Account is a way you can save on taxes while investing for the long run. While there are many different kinds of IRAs, the main benefit to all of them is that you don't have to pay tax on your investment earnings as they occur. For example, if you sell a stock in your IRA and make a $2,000 profit, you don't have to report that income when you file your taxes that year. However, with the exception of Roth IRAs, which allow for tax-free withdrawals, you'll have to pay income tax when you take money out of your IRA.
When you open an IRA account, you get to choose who will receive your account when you die. The recipient is known as a beneficiary. If someone bequeaths you an IRA, the account becomes known as an inherited IRA, also called a decedent IRA. Owners of traditional IRAs have to start taking an IRS-determined minimum amount out of their IRAs after they turn 70 1/2 years of age. However, inherited IRAs have their own rules when it comes to distributions. These distribution rules vary based on whether you are the spouse of the deceased owner and whether or not the decedent had already begun taking out required distributions.
Non-Spousal Beneficiary IRA Distribution Rules
As the owner of an inherited IRA, you generally have to take money out of the account every year, even if you are under age 70 1/2. If the original owner of the IRA had already begun taking out his minimum required distributions, you have to continue taking distributions every year. To calculate the correct amount, divide the account value of your inherited IRA at the end of the year by your life expectancy, as determined by the IRS in Table 1. For every year after that, lower your life expectancy by 1 and use the same calculation.
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For inherited IRAs where the original owner had yet to begin taking required distributions, you have two options. The first option is to take out regular distributions every year based on IRS Table 1, just as if the decedent had already begun taking distributions. You also have the option to withdraw the entire balance by the end of the fifth year after the original owner's death.
If you inherit an IRA, you need to follow the same tax rules as the original owner. Distributions from traditional IRAs are treated as ordinary income, the same as the wages on your paycheck. You have to report these withdrawals to the IRS and pay ordinary income tax on them. If you inherit a Roth IRA, your distributions are tax-free. One benefit of inheriting an IRA is that you're not liable to the early distribution rules. Typically, if you take money out of an IRA before you turn age 59 1/2 you owe a 10 percent penalty, on top of any taxes you owe. This rule is waived for beneficiary IRAs.