Inherited IRA Options
IRAs are Individual Retirement Accounts that shelter you from taxes during your working years. Then, during retirement, the IRA allows you to draw an income. This income may be taxed, if it's a traditional IRA, or it may be tax-free, if it is a Roth IRA. However, if you inherit an IRA, you must understand how inherited IRAs work, and what options you have.
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Types
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If you inherit a traditional IRA, you are taxed on all distributions that you take from the account. The IRA distributions are added to your income and taxed in the same way that they were taxed for the original IRA owner. Likewise, an inherited Roth IRA is exempt from income tax, since Roth distributions are tax-free.
Spouse
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If you received an IRA from a spouse, you have two options. You may treat the IRA as your own, or you may roll the IRA into an IRA that you own. When treating the IRA as your own, you may make contributions to the IRA, withdrawals as well as invest in any investments within the IRA as though you were the original IRA owner. If you transfer the IRA to your own, the funds are transferred tax-free. You may also take a lump sum distribution if you wish.
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Non-Spouse
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If you inherit an IRA from a person who is not your spouse, then you cannot treat the IRA as your own. This means you may not make contributions to the account. You must take withdrawals from the account, however, based on your life expectancy or any amount that would liquidate the IRA sooner. This includes taking a lump sum distribution.
Misconceptions
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A common misconception is that you can make contributions to an inherited IRA. This is only true if you inherit the IRA from your spouse. In all other cases, you must take the money from the account. The original IRA is transferred to an inherited IRA account. From this account, the IRA may be stretched out over your lifetime, or lump sum distributions may be made.
Considerations
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When deciding what to do with an inherited IRA, analyze your tax situation. IRA income adds to your ordinary income. If you increase your income substantially, you may push yourself into a higher tax bracket. This would increase taxes on all of your income, not just your IRA income. It may be in your best interest to stretch the payments out over your lifetime unless the lowest annual distribution would constantly put you in a higher tax bracket. In these instances, you may consider taking the lump sum distribution and paying the tax in the first year.
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