Paying Taxes on Inherited IRA
Inheriting an IRA might seem like a financial windfall, until you are confronted with all the tax implications the inheritance creates. There are different options available to beneficiaries, with certain restrictions contingent on who is actually inheriting the asset. Additionally, the type of IRA, Roth or traditional, impacts the tax liabilities.
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Estate Tax Implications
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The 2011 federal estate transfer tax is 35 percent. All assets, including the IRA, are included in the estate. If the estate value falls under $5 million, no transfer tax is owed. If the estate is over the $5 million threshold, all assets are taxed 35 percent or $350,000 per million. Keep in mind that the IRA avoids probate and is not subject to trust distribution unless the estate or trust is named as the beneficiary. Avoiding probate means the IRA moves to beneficiaries without a creditor making a claim on it, helping preserve the IRA asset through the overall estate.
Income Tax
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There are two IRA structures, tax-deferred and tax-free. The tax-deferred IRA, also known as the traditional IRA, adds distributions to income taxes. Normal Roth IRA distributions do not generate a taxable event and are tax-free. While both types of IRAs are included in the taxable estate for transfer tax purposes, the income tax issue is contingent on the type of IRA. Inheriting a traditional IRA means distributions are added to the beneficiary's income taxes. The Roth IRA is distributed tax-free except when it doesn't meet the five-year rule. A Roth IRA not yet owned for five years by the IRA owner has earnings added to income until the five-year mark is met.
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Reducing Income Taxes
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If estate taxes and income taxes are taxed at the highest rates, an IRA beneficiary might lose more than 70 percent of the IRA to taxes. Certain beneficiaries have options to reduce the immediate income tax issues on traditional IRAs. A surviving spouse can continue the IRA. A living person, including a spouse, child or grandchild can take a lump-sum distribution, take payments over five years or roll the IRA into a beneficiary IRA. The lump sum has the largest tax effect, immediately adding everything to income, while the five-year distribution reduces it over time. The beneficiary IRA allows a beneficiary to continue the tax-deferred growth, taking minimum distributions annually based on his age. The last option not only reduces income tax issues but allows for significant asset growth when inherited by younger children or grandchildren.
Other Considerations
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Every state has different income and estate tax issues. Check with local tax authorities to confirm any further tax considerations on inherited IRAs. Also know that an inherited IRA that is already taking required minimum distributions must take the RMD out before Dec. 31 in the year following the owner's death. Failure to take the RMD out results in a 50 percent tax penalty on the amount you should have taken out.
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