Taxability of Inherited Traditional IRAs
When a loved one passes away and leaves you a traditional Individual Retirement Account (IRA), you are suddenly presented with a number of time-sensitive decisions that will affect how the Internal Revenue Service (IRS) taxes your inherited assets. The good news is that, if you are proactive, you can take steps to minimize your tax burden and maximize the IRA's tax shelter.
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Beneficiary Types
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If you inherit a traditional IRA, your options depend largely on your relationship to the original owner. Traditional IRAs you inherit from your spouse you may treat as your own -- simply put your name on it and continue making contributions and delaying distributions until the year you turn 70 1/2, if you wish. Non-spouses must quickly begin drawing down the account or risk a 50 percent IRS penalty for "excess accumulations."
Beneficiary Options
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Nonspouse beneficiaries, and spouse beneficiaries who choose not to treat an inherited IRA as their own, have two options. They can empty the IRA at any point within five years, or begin taking what the IRS calls required minimum distributions (RMDs) by Dec. 31 the year after the decedent passes away. If you decide to withdrawal the money within five years, you can take a portion of the IRA each year within that period, or leave the money and withdraw it all at the end.
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Required Minimum Distribuitons
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To calculate your RMD, divide what the IRA was worth on the previous Dec. 31 by your life expectancy. The IRS publishes life expectancy tables for determining RMDs in its Publication 590. Usually, you calculate RMDs based on your own life expectancy, but there are two exceptions: if the original owner was 70 1/2 or older but did not take his own RMD before he died, you must withdraw the required amount by Dec. 31 the year of his death. Also, if the original owner died after turning 70 1/2, you must calculate RMDs based on his life expectancy rather than yours if his life expectancy was longer.
Benefits
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If you do not need the money immediately, there are a number of tax advantages to taking RMDs rather than withdrawing an inherited IRA in a lump sum. RMDs are based off your life expectancy: the younger you are, the smaller your required annual withdrawal. Though non-spouse beneficiaries are barred from contributing to an inherited IRA, they can still buy and sell assets inside the account, and earnings on those assets are still tax deferred. The longer you can keep money inside the IRA, the longer you can let your tax-free earnings compound.
Considerations
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RMDs are the best way to minimize your tax burden and extend the life of the IRA. But if you decide on the five-year option, you can make smart decisions about your assets as well. The IRS taxes traditional IRA withdrawals at your income tax rate. If the value of your inheritance would place you in a higher tax bracket, consider taking a portion of IRA's worth throughout the five-year period to lower your tax rate.
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References
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