Is an IRA Considered Income When You Are the Beneficiary?
The tax-deferred structure of an IRA is one way to build assets up when the IRA owner is alive. When the IRA owner dies, the tax liabilities to beneficiaries are often substantial. Not only is the money distributed from a traditional IRA added to income, there may also be estate transfer taxes to contend with. Roth IRA distributions do not get added to income.
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Taxable Income Distributions
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Inheriting a traditional IRA means you are inheriting tax-deferred money. When the money comes out of the tax-deferred structure, it will be added to income. It doesn't matter if the IRA owner distributes it or you as the beneficiary distribute it. A beneficiary has several options to try to mitigate some of the initial tax liabilities. Distributions options are different for a surviving spouse compared to non-spousal beneficiaries. A spouse may continue the IRA as her own, take a lump-sum distribution, spread distributions over five years or roll it over into a beneficiary IRA. Non-spousal beneficiaries have all the same options except for continuing the IRA as if it was his own.
Estate Taxes
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The 2011 federal estate transfer tax rules require all estates exceeding $5 million at the time of the death to pay a 35 percent federal transfer tax. The value of the IRA at the time of death is included in the taxable estate. This means that if a person inherits an estate of $5 million and takes a lump-sum distribution of $1 million out of the IRA at a 39.9 percent income tax bracket, the $1 million may only be worth $251,000. State transfer taxes vary and could increase the amount owed, dwindling down the inheritance even more.
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Understanding Options
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The IRA beneficiary, or his legal guardian if he is a minor, makes all decisions about what to do with the inherited IRA because an IRA avoids probate. What this means is the estate may go through probate or have a trust executor liquidate the estate based on the trust, but the IRA is independent. Creditors to the estate have no hold on the IRA and cannot use it as part of the estate closing. This has a significant impact in many cases. For example, say John leaves his IRA to his 10-year-old granddaughter, Sara, for college savings. When John dies, Sara's mom does not need to use the IRA to help close out debts John had, such as a mortgage or car lease.
Stretching to Reduce Taxes
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Using the five-year distribution or rolling the money into a beneficiary IRA reduces the income taxes owed in any one year but still requires the entire IRA value to be included in the estate. When a beneficiary rolls the IRA into a beneficiary IRA, he must take required minimum distributions starting no later than December 31 in the year following the death. The distributions are based on the beneficiary's age, thus distributions are smaller, with less tax impact. Taking less out also allows the beneficiary to continue to grow the asset tax-deferred.
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