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Understanding the taxes on an inherited IRA and the inherited IRA rules

What is an inherited IRA? What are the taxes on an inherited IRA?

An inherited IRA refers to an IRA that is passed from the original account holder to a beneficiary after the account holder dies. It is important for people to understand the inherited IRA rules for different beneficiaries and heirs.

Do you have to pay taxes on an inherited IRA? Whether you will have to pay tax on an inherited IRA will depend on the type of IRA that you are receiving under the inherited IRA rules. You will usually not have to pay inherited IRA taxes if you inherit a Roth IRA. If you inherit a traditional IRA, you will generally have to pay taxes. Spouses and non-spousal beneficiaries have different rules for inherited IRAs. The taxes on an inherited IRA will be assessed at the time that distributions are taken unless it is an inherited Roth IRA.

Understanding the taxes on an inherited IRA

Inherited IRA statistics

The CPA Journal reports that 48.9 million households own IRAs with a collective value of $5.4 trillion. Of these IRAs, 39 percent are owned by people who are in the baby boomer generation. On average, Americans who are currently 65 years old can expect to live for an additional 19.4 years.

With the greater number of people who are older holding IRAs, a substantial amount of assets will be transferred from baby boomers to their heirs in the next 20 years. It is important for you to understand the inherited IRA rules and the taxes on an inherited IRA if you will receive assets from your parents, from a spouse, or will receive an inherited IRA from a non-spouse.

What are the inherited IRA rules?

Taxes on an inherited IRA are assessed on the distributions that you take in the year that you take them. There are different inherited IRA rules for spouses and non-spouse beneficiaries. Spouses who inherit IRAs have several options under the inherited IRA rules. They may opt to treat the IRAs as their own or to instead to be treated as if they are non-spouse beneficiaries.

Under the inherited IRA rules, spouses can choose to roll the assets over into their own IRAs so that they will not have to begin taking required minimum distributions before they reach age 70 1/2, which might help them to avoid being pushed into a higher tax bracket and being forced to pay more tax on an inherited IRA.

Non-spouse beneficiaries must begin taking required minimum distributions within one year of the deaths of the original IRA account holders under the IRA distribution rules for beneficiaries. If they do not, they will have to withdraw the entire balances within five years of the original owners’ deaths. Non-spouse beneficiaries can withdraw the money at any time, but they will have to pay inherited IRA taxes on the amounts that they withdraw.

Taxes on inherited IRAs, inherited Roth IRAs and inherited 401ks

Traditional inherited IRAs, inherited Roth IRAs and inherited 401k accounts

Traditional inherited IRAs are traditional IRAs, SEP IRAs, and SIMPLE IRAs that are left to beneficiaries when the account owners die. SEP IRAs and SIMPLE IRAs become traditional inherited IRAs after the account holders pass away and follow the same rules.

Inherited Roth IRAs allow the beneficiaries to take withdrawals without paying taxes. However, they cannot choose to keep the money in the Roth IRA accounts like the original account holders were able to do.

Inherited 401(k) accounts are 401(k) plans that are inherited from spouses or from non-spouses. Just like you have to pay tax on an inherited IRA, you also have to pay tax on an inherited 401(k). Under the rules on an inherited 401(k), the taxes on an inherited 401(k) are assessed at the time that you take distributions. The inheritance tax rate when you take distributions from an inherited 401(k) or a traditional IRA is your ordinary income tax rate.

The rules on an inherited 401(k) differ depending on whether you are a spouse or a non-spouse. The inherited 401(k) rollover rules allow spouses to roll the funds over into their own accounts. However, the inherited 401(k) rollover rules do not allow non-spouse beneficiaries to roll the funds over into their own accounts. You can roll the funds over into an account that you have designated as an inherited IRA under the inherited 401(k) rules.

IRA beneficiaries

There are different rules for each type of beneficiary of an IRA. A beneficiary of an IRA may include a spouse, a non-spouse, or an entity such as a trust. A spouse who is a beneficiary of an IRA may treat the inherited IRA as if it is his or her own. He or she may also choose to roll the funds over or to act as if he or she is a non-spouse beneficiary.

When the spouse is the beneficiary of an inherited IRA from an owner who died on or after the required beginning minimum distribution date, the spouse has the following options:

  • Can treat the IRA as his or her own
  • Distribute the assets of the IRA over his or her life using a life expectancy table
  • Distribute the assets based on the owner’s age beginning in the year of the death

When the spouse is the beneficiary and is inheriting an IRA from a person who died before reaching the required beginning date under the inherited IRA RMD rules, he or she has the following options:

  • Treat the IRA as his or her own
  • Withdraw the entire balance within the five years that follow the spouse’s death
  • Take distributions under the life expectancy table with the distributions not starting until the owner would have reached age 70 1/2 under the inherited IRA RMD rules

Withdrawing the entire balance by the end of the fifth year has its drawbacks. If you choose to withdraw all of the money in a lump sum, you will have to pay tax on an inherited IRA at your ordinary income tax rate. This can mean that cashing out your spouse’s entire balance could push you into a higher tax bracket in the year in which you take the distribution and force you to pay more tax on an inherited IRA.

non-spouse beneficiary of an IRA has a few options under the IRA rules for beneficiaries. He or she can cash in the IRA’s entire balance by Dec. 31 of the year that follows the death of the original account owner or start taking required minimum distributions by that date under the IRA RMD rules for beneficiaries. He or she can instead opt to cash it in within five years of the death.

Take all of these options into consideration as an IRA beneficiary. If a distribution pushes you into a higher tax bracket, you will pay a higher inheritance tax rate in the year that you take it. It may be best to try to take higher distributions during the years in which you expect to be in a lower tax bracket.

Finally, a non-spouse beneficiary of an IRA can choose to stretch out the distributions by establishing an inherited IRA account. The beneficiary of an IRA can set up the inherited IRA account and then take required minimum distributions according to a life expectancy table.

When an inherited IRA is split between siblings, it is important to understand the IRA transfer rules. The custodian of the IRA should be able to transfer the funds to separate IRAs that the siblings have set up with themselves as the beneficiaries.

When an inherited IRA is split between siblings, it is important to avoid taking the distributions directly if you want to avoid paying taxes at the time that you take them. The IRA transfer rules allow you to ask for a trustee-to-trustee transfer to your inherited IRA account so that you can allow the money to grow on a tax-deferred basis for a longer period of time.

An entity such as a trust or an estate can also be a beneficiary of an IRA. If you are the representative of an entity that has inherited an IRA, the entity will likely have to take distributions of the entire IRA within five years. The only exception would be if all of the beneficiaries of the trust are individuals. In that case, the distributions may be stretched out according to the life expectancy table of the oldest beneficiary.

Beneficiary inherited IRA and taxes on an inherited 401(k)

Different rules apply for the taxes on an inherited IRA and an inherited 401(k), depending on the type of account. An IRA beneficiary of an inherited traditional IRA must pay taxes on inherited IRA distributions when the money is taken out of the account.

Beneficiaries of traditional IRAs may choose to cash out the entire IRA account immediately after the original owner dies. However, using other strategies for IRA withdrawals can help to reduce your tax bill and to defer having to pay taxes on an inherited IRA for years.

A stretch IRA allows you to take required minimum distributions over your life based on your life expectancy. The stretch IRA option allows most of the balance of your inherited account to grow tax-deferred. The required minimum distributions that you must take will be included in your taxable income during the years in which you take them. You will not have to pay taxes on an inherited IRA for the money that is inside of the account until you start to take distributions.

If you inherit a Roth IRA, different IRA rules for beneficiaries apply as long as the account was funded for at least five years before the owner’s death. In that case, you will not have to pay taxes on an IRA that is a Roth IRA that you have inherited. If the Roth IRA was not funded for five years or longer, you will want to consult with a tax adviser.

While you have to pay taxes on an inherited IRA, you do not have to pay taxes on the distributions when you inherit a Roth IRA as a non-spouse. There are no taxes on inherited Roth IRA distributions. However, you must begin taking distributions from the account starting by Dec. 31 of the year that follows the death of the account owner. If you do not, you must withdraw all of the funds by the end of the fifth year after the death.

Non-spouse beneficiaries can roll over the money from a Roth IRA that they have inherited into inherited Roth IRA accounts under the inherited IRA rollover rules. However, they cannot roll the funds over into their existing Roth IRA accounts, and they will have to take required minimum distributions on an annual basis. However, while you cannot just leave the money sitting in the account, you will not have to pay taxes on inherited Roth IRA accounts.

If you are a spouse who inherits a Roth IRA or a traditional IRA, the inherited IRA rollover rules allow you to roll the funds over into your own account. If you are a spouse who is inheriting an IRA that is a Roth IRA, you will not have to pay taxes on an inherited IRA, and you can allow the funds to continue to grow on a tax-deferred basis.

The rules on an inherited 401(k) state that you will have to pay taxes. The  distributions that you take will not be subject to a 10 percent early withdrawal penalty. This applies regardless of whether you are younger than age 59 1/2.

Under the rules on an inherited 401(k), you will pay taxes on the amount of the withdrawals during the year that you take them. The inherited 401(k) rules allow spouses to roll the funds over into their own accounts but do not allow non-spouse beneficiaries to commingle the funds in their own accounts.

If the account owner did not have a designated beneficiary, the proceeds of the IRA will be paid to the estate. The account must be fully distributed within five years. This cuts short the ability of the funds in the account to grow because of limiting the life of the IRA.

If you learn that you are inheriting an IRA and either want to avoid inherited IRA taxes or to allow the assets to pass to other beneficiaries instead, the option that you have is disclaiming an inherited IRA. If you are inheriting an IRA and want to disclaim it, you must do so within nine months of the death of the account holder. You also must disclaim the IRA before you take possession of any of the assets held in it.

How do taxes on an inherited IRA work?

Importance of choosing a beneficiary for your IRA

Under the IRA beneficiary rules, the proceeds of your IRA are not passed through the provisions of your will. It is vital for you to choose a beneficiary for your IRA. If you do not, the proceeds of your IRA will pass to your estate and will be passed according to the intestacy laws of your state instead of how you might wish the account to be handled.

When you open your IRA account, you can designate a beneficiary under the IRA beneficiary rules on the beneficiary designation form. This form allows you to specify how the funds in your account will be handled after you die according to the IRA beneficiary rules. You can name your spouse, child, friend, or a charity or trust as the beneficiary to your IRA.

Other factors for beneficiaries to consider

In addition to knowing the IRA distribution rules for beneficiaries, there are some other factors that you should consider. You first need to determine whether you are listed as a beneficiary of another person’s IRA. Remember that under the IRA distribution rules, the beneficiary who is named on the beneficiary designation form will receive the proceeds of the IRA. The beneficiary designations supersede wills.

If you are named as a beneficiary and are inheriting an IRA from a parent or have inherited an IRA from a spouse, you should request a trustee-to-trustee transfer of the funds in the inherited account. The distributions from an inherited IRA can be invested in other accounts. You should also make certain that you understand the IRA RMD rules for beneficiaries.

One important factor to consider when you are wanting to minimize the taxes on an inherited IRA or to minimize taxes on an inherited 401(k) is the commingling of inherited IRAs. If you are inheriting an IRA from a parent or have an inherited IRA from a non-spouse, you cannot simply roll the funds over into your own IRA. You instead must open an inherited IRA and name yourself as the beneficiary.

The IRA RMD rules for beneficiaries state that you must take required minimum distributions from the inherited IRA account. Disclaiming an inherited IRA is another option if you want to avoid paying taxes on an inherited IRA or want the proceeds to pass to other beneficiaries. Finally, if you are the beneficiary of an inherited IRA from a non-spouse, you will not have bankruptcy protection with your inherited IRA.

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