Is an Inherited IRA Taxable?
When a family member dies and leaves an IRA to you, you become the beneficiary. Because IRAs are tax shelters, they are subject to special rules and regulations. These rules apply even after the death of the IRA owner. Make sure you understand how tax rules affect your inherited IRA.
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Types
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Determine what type of IRA you inherited. There are two types of IRAs you may have received. The first is a Traditional IRA, which allows pretax contributions and taxes the withdrawals at ordinary income tax rates. A Roth IRA, the other type of IRA you may have inherited, would have allowed the IRA owner to make after-tax contributions in exchange for tax-free withdrawals.
Significance
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The significance of a Traditional IRA is that when you receive the funds, the assets will be added to your gross income unless the original IRA owner was your spouse. If you are receiving your spouse's IRA, you may roll it into an existing IRA or a new IRA, or treat the IRA as your own. If the original IRA owner was not your spouse, the distribution may increase your marginal tax rate as well as your gross income if the inheritance is large enough. The significance of a Roth IRA is that the distributions made to you will be tax-free.
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Benefits
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The main benefit of receiving an IRA as an inheritance is that you can take distributions over time from a Traditional IRA, or you can receive tax-free distributions from a Roth IRA. Your taxes would be either eliminated or spread out over your lifetime.
Misconceptions
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A common misconception is that you must take a lump sum distribution from a Traditional IRA. You may be able to stretch the IRA withdrawals over your lifetime with an annuity, if the original IRA owner purchased an annuity prior to death. Alternatively, you may choose to withdraw all of the money by Dec. 31 of the fifth year following the owner's death, or spread out the payments over your lifetime using the Internal Revenue Service's mortality tables as a guide for lifetime payments. Your life expectancy will be based on your current age, and the payments would extend over your lifetime to your expected age of death.
Expert Insight
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If possible, choose the payment option that lowers your taxes the most. While a lump sum distribution gets your inheritance into your hands immediately, much of the money may be lost to taxes, and your marginal tax rate could cause your other regular income to be taxed at much higher rates than they otherwise would be.
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