Usually, when you sell an inherited asset, the cost basis is different from that of the person who left it to you. For example, if you sell 1,000 shares of stock inherited form your father and priced at $40 per share at the time of his death even though he bought them for $10 each, your cost basis would be $40,000 instead of $10,000. You pay capital gains tax only if you sell the asset for more than your cost basis. When you inherit assets from an individual retirement arrangement, though, the rules are different.
Traditional IRA Basis
For income tax purposes, a traditional IRA funded with tax-deductible contributions has no basis. Since everything that went into it was tax-free, everything that comes out is taxable. When you take distributions from an inherited IRA, the entire distribution is taxable as regular income -- just as if it was taken from an IRA funded with your own contributions.
Traditional IRA Estate Tax Basis
For estate tax purposes, a traditional IRA carries a fair market value as of the date of death. If an IRA has $1 million in it, that $1 million will be included in the value of the estate, even though it passes through to heirs with a zero dollar value. The person who inherits the IRA gets a special tax deduction equal to all of the estate tax that was paid on the IRA since IRAs are technically considered "income in respect of a decedent." This can help to cancel out any tax liability on the IRA's estate tax basis. However, when the estate passes the IRA through, it will still have to pay the estate tax on the IRA if the estate exceeds the maximum tax-free size, which is $5.25 million in the 2013 tax year.
Roth IRA Basis
A Roth IRA's basis carries forward through death just as that of a traditional IRA. However, this rule benefits you with a Roth since it means that you'll be able to take distributions from a Roth IRA without paying any income tax on them as long as the original account holder had the Roth IRA for at least five years. As with a traditional IRA, though, the Roth IRA's value as of the date of death serves as its basis for estate tax purposes.
When you inherit a traditional IRA, you generally have two choices for how you distribute the funds. You can take the balance in a lump sum, all of which will be taxable as regular income, or you can put it in an inherited IRA account and spread your distributions out over either five years or your expected lifetime. The latter option is only available if the decedent was already taking or was required to take annual minimum distributions. If you inherit a Roth IRA, you can take a tax-free lump sum distribution or put the funds into an Inherited Roth IRA account and let them continue earning for you.
If you inherited an IRA -- either Roth or traditional -- from your spouse, you have a third option. You can roll the funds directly into your own Roth or traditional IRA. Like the already had in the your own account, the rolled-over funds will be non-taxable.
- IRS: Is the Money Received from the Sale of Inherited Property Considered Taxable Income?
- Fidelity: If You Are a Non-Spouse IRA Beneficiary
- Forbes: Inherited IRA Rules: What You Need to Know
- The Wall Street Journal: Inherited IRAs: a Sweet Deal
- Charles Schwab: You've Just Inherited a Retirement Account. Now What?
- Fairmark.com: Inherited Roth IRA
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.