Inheriting an individual retirement account (IRA) can be a great monetary blessing for the recipient, but it can also raise many questions as to the rights and obligations associated with the transfer of money.
One of the most common questions that benefactors have when inheriting an IRA is, “Do I have to pay taxes?”
The short answer is, it depends.
If you inherit a Roth IRA, then you won’t owe any taxes to the IRS since the taxes are taken out when money is contributed. You can take the money out or let it continue to grow, without the tax liability.
But for traditional IRAs, where the money is tax-deferred, there are various rules that apply to certain individuals and situations. These rules, and whether or not you follow them, determine when taxes are due.
Retitle the IRA
If you want to avoid paying taxes on an inherited traditional IRA, and you are the spouse of the original account holder, then you need to retitle the IRA and put it in your own name. If you withdraw any of the money, then you will owe taxes on that amount right away. If you leave the money in the account, then you will start taking required minimum distributions once you turn 70-1/2. This is how the IRS begins to claim the taxes due to them.
If you are a non-spouse and you inherit an IRA, then you do not have the option of retitling the account in your own name. Instead, you will have to retitle the account as an inherited IRA, and you will begin taking required minimum distributions right away.
Take the Lump Sum
For some who inherit an IRA, the option to cash out the account is an attractive one. Taking the lump sum, however, means that the IRS will expect you to pay taxes on the entire amount, right away. In contrast to retitling the account, either in your own name or as inherited, this approach forces you to pay taxes sooner rather than later and reduces the overall amount that you are allowed to keep.
Spouses Younger than 59-1/2
There are special circumstances for spouses who are younger than 59-1/2 years old and who inherit a traditional IRA. If he or she decides to cash out the account, then they will have to pay a 10 percent tax penalty for early withdrawal on top of the regular income tax. If the spouse retitles the IRA as an inherited IRA until they are age 59-1/2, at which time they would retitle it in their own name, then they can avoid the early withdrawal penalty and still get some of the money via required minimum distributions.
While an IRA inheritance can be confusing when it comes to taxes and withdrawals, transfers and retitling, a taxation lawyer can make the process easier on you. Get a referral to a taxation attorney by contacting the Lawyer Referral and Information Service at (619) 231-8585, online chat, or the online referral request form.