“Joe and Al, I have two separate IRAs, one a nondeductible and one is a regular. They have always been in separate accounts, but I fill out the 8606 form when I take RMDs. These IRAs have separate beneficiaries (Not related to each other). How is each IRA taxed after inheritance? Do each need a copy of my latest 8606 form? Would it be better if I empty one account through RMDs? Thanks. Ken”

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How Are Inherited IRAs Taxed?

Inheriting an IRA can be a significant financial benefit, but it’s important to understand how these accounts are taxed to avoid any unexpected surprises. While IRAs offer tax advantages during a person’s lifetime, the tax rules change when an IRA is inherited by someone else. In this article, we will explore the taxation of inherited IRAs and provide insights into what you need to know about this crucial topic.

Inherited IRAs, also known as beneficiary IRAs or stretch IRAs, are individual retirement accounts left to someone after the original account owner’s death. The tax treatment of these accounts depends on several factors, including the relationship between the deceased account owner and the beneficiary, the type of IRA, and the timing of distributions.

Spouses have more flexibility when it comes to inherited IRAs. If a surviving spouse is the sole beneficiary, they have the option to treat the IRA as their own. They can roll the inherited IRA into their existing IRA or convert it into their own account. By doing so, the surviving spouse can delay required minimum distributions (RMDs) until they reach 72 years of age, or withdraw funds penalty-free if they are older than 59 ½.

For non-spouse beneficiaries, the rules are slightly different. Non-spouse beneficiaries cannot merge the inherited IRA with their own. Instead, they have two options: taking a lump-sum distribution or setting up an inherited IRA. The tax consequences vary depending on the chosen option.

If a non-spouse beneficiary decides to take a lump-sum distribution, the entire inherited IRA will be distributed to them. However, this approach could lead to a significant tax bill as the distribution is generally subject to ordinary income tax. Depending on the size of the inherited IRA, this may push the beneficiary into a higher tax bracket.

Setting up an inherited IRA, on the other hand, offers potential tax advantages. With this option, the beneficiary can “stretch” the distributions over their lifetime or a fixed period, depending on the age of the original account owner at the time of death. The advantage of stretching the distributions is that it allows the funds to continue growing tax-deferred, potentially reducing the annual tax burden.

The RMDs for inherited IRAs are determined based on the beneficiary’s age, using the IRS life expectancy table. The beneficiary must withdraw at least the minimum amount each year, but they also have the flexibility to withdraw more if needed.

It is crucial to note that the rules for inherited IRAs underwent changes with the passage of the SECURE Act in December 2019. Under the new law, for non-spouse beneficiaries, the inherited IRA must be fully distributed within ten years of the original account owner’s death. The ten-year rule replaced the previous option of stretching distributions over the beneficiary’s lifetime. However, there are exceptions to this rule for certain eligible designated beneficiaries, such as surviving spouses, minor children, and disabled individuals.

In summary, if you inherit an IRA, understanding the tax implications is essential. Spouses have more flexibility in accessing the funds and can treat the inherited IRA as their own. Non-spouse beneficiaries can choose between a lump-sum distribution or setting up an inherited IRA. It is advisable to consult with a financial advisor or tax professional to navigate the complexities of inherited IRAs and make informed decisions that align with your financial goals and tax strategies.