Inheriting an individual retirement account (IRA) can be both a blessing and a curse: A blessing because of the obvious financial windfall, but a curse because distributions from inherited IRAs are taxed in the same way they would have been taxable to the decedent. Unlike most other assets you inherit, you don't get a basis adjustment when you inherit an IRA.
As tax-deferred retirement plan, distributions from an inherited traditional IRA is fully taxable, even for a beneficiary. The only way a portion of the distribution won't be taxed is if the decedent made nondeductible contributions to the traditional IRA, meaning she put money in and didn't claim a deduction. If so, you split your distributions based on the percentage of nondeductible contributions in the IRA. For example, if the inherited traditional IRA is worth $100,000 and it contains $28,000 of nondeductible contributions, 28 percent of your distribution comes out tax-free.
Roth IRAs use different rules for determining taxes. If the decedent had the account open for at least five years, all your distributions are tax-free because it counts as a qualified distribution. If the decedent died before five years, you get to take out the contributions made to the account tax-free. However, once you've taken out all the contributions, you must pay taxes on the distributions of earnings.
Taxable distributions from an inherited IRA count just like any other ordinary income on your tax return. Even if you invest the money in the account in stocks or other capital assets, it won't qualify for long-term capital gain rates. Therefore, the tax rate depends on how much other income you have and your filing status. For example, if you fall squarely within the 28 percent tax bracket, and you take a $10,000 taxable distribution from your inherited IRA, you'll pay $2,800 in taxes.
With an inherited IRA, you don't have to worry about early withdrawal penalties because beneficiary distributions are exempt, even if neither you nor the decedent had turn 59 1/2 yet. However, you do have to worry about the 50 percent penalty that applies when you don't take required distributions. As a beneficiary, you generally have to either empty the account by the end of the fifth year after the decedent died or take minimum annual distributions every year until the account is empty. If you are the decedent's spouse, you can avoid these required distributions if you elect to treat the account as your own.
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