Does the Beneficiary Have to Pay Taxes on an IRA Received?
Living benefits are the primary goal of an Individual Retirement Account, IRA; living benefits are considered supplemental income anytime after age 59-and-a-half. Passing funds to beneficiaries is a secondary goal for IRA owners because the account avoids the time and cost of probate. IRA beneficiaries are often hit hard with taxes in spite of the IRA owners' best intentions.
Other People Are Reading
-
Estate Transfer Tax
-
An IRA is considered part of the taxable estate regarding federal transfer taxes, otherwise called estate taxes. The 2011 federal transfer tax rate is 35 percent on all estates with more than $5 million in assets. Smaller estates have a zero transfer tax rate, making $5 million an all-or-nothing threshold. If a $1 million IRA is subject to the federal transfer tax, $350,000 is automatically owed to the IRS for the IRA value.
Income Tax Issues
-
Two types of IRA accounts exist, a traditional or a Roth. The traditional IRA adds distributions to income taxes because all money in the account is pretax. The Roth IRA doesn't add distributions to income because money put in is after-tax money and allows earnings to grow tax free. When the beneficiary inherits the IRA, the same distribution rules apply. Traditional IRA distributions are added to income taxes while Roth distributions are not. The top income tax bracket, in 2011, is 35 percent, thus, a lump sum from a fully taxed traditional IRA inheritance with estate taxes that can eat 70 percent of the IRA immediately.
-
Options to Distribute
-
A few options are available to persons inheriting an IRA that help reduce the immediate tax bill. A non-living entity does not have the same distribution options. All beneficiaries, living or non-living, can elect a lump-sum distribution taking the entire IRA out at once. A surviving spouse has an option, which is to continue the IRA. Spouses can make contributions, take distributions or co-mingle the money with other IRA assets without penalty. A surviving spouse also has the other options available to all other living person beneficiaries. Taking distributions over five years is one option. Another option is rolling the inherited IRA into a beneficiary IRA. The beneficiary IRA requires minimum annual distributions based on the beneficiary's age, which greatly reduces the amount withdrawn for significantly younger beneficiaries.
Taxes on Options
-
There is nothing the IRA beneficiary can do to mitigate federal transfer taxes. The IRA is included whether it is distributed or not. The lump-sum option adds the entire taxable distribution to the beneficiary's income, possibly bumping him into a higher tax bracket on all income sources. The five-year distribution allows beneficiaries to stretch income over five years, possibly preventing tax-bracket bumps and reducing the immediate tax liabilities. In trying to preserve the IRA asset, the beneficiary IRA is the most strategic option, allowing even a minor child to continue the IRA for many years. The growth remains tax deferred with only the required distributions withdrawn.
-
