The more money you take out of an inherited IRA, the more tax you pay. If you inherit an IRA from your spouse, you can keep money in the account until you retire. If you inherit from anyone else, you must make annual minimum withdrawals and pay tax on them until the account is empty.
There's nothing special about the money you withdraw from your inherited IRA. It's income, like wages or commissions, so you lump your withdrawals in with your other income and calculate tax on the total, based on your income tax bracket. You're always free to take out more than the minimum required amount, which is calculated using your own life expectancy. You pay tax on the money in the year you withdraw it, regardless of whether you take out a lump sum or several installments.
Normally, everything you take out of the IRA is taxable because it went in tax-free. Sometimes, however, because of former account owner's financial situation, he wound up depositing some money but still paid taxes on it. In that case, you withdraw that portion of the money tax-free, to avoid double-taxation. You don't have the option to single out taxable or tax-free withdrawals, though: if 32 percent of the IRA is tax-free, then 32 percent of every withdrawal is tax-free.
When you don't withdraw the minimum from your IRA, your tax bill goes way up. The IRS hits you with a 50 percent tax penalty if you don't meet the minimum: if you have to withdraw $3,500 and you only withdraw $700, that equals a $1,400 extra tax hit: half of the $2800 you failed to withdraw. If you show the IRS that you made an honest mistake and you're taking steps to fix the problem, you may get the added tax waived.
As a beneficiary, you must have the account trustee transfer the deceased's money into a beneficiary IRA. You identify the account with your name, the original owner's name and a statement that you're her beneficiary. If you fail to name the account properly, the IRS treats the transfer as if you'd simply withdrawn everything from the IRA and deposited it in your own bank account. That makes the entire withdrawal, except for any tax-free parts, taxable.
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