If you are the beneficiary of an IRA, taxes must eventually be paid on the proceeds of the IRA. However, depending on your beneficiary status, there can be a lot of flexibility as to when the taxes must be paid. Check out the different options for an inherited IRA before taking the step of cashing out the account and incurring a big tax bill.
Taxes Must Be Paid Eventually
An IRA is a tax-deferred account, and Internal Revenue Service (IRS) rules force taxes to be paid on the account eventually. If you choose to withdraw any money from the inherited IRA, that money will be taxable for the year in which you made the withdrawal. Depending on your status as a beneficiary, you have some control as to when withdrawals are taken and taxed. Any money left in the IRA can grow tax-deferred until it's eventually taken out of the account.
Your Beneficiary Status
If, as the beneficiary of an IRA, you are the spouse of the original IRA owner, you can switch the IRA to your name and treat it like you were the original owner. This means you do not have to take any withdrawals until you reach the minimum required distribution age of 70 1/2. If you are a non-spouse beneficiary, you have the two options of either withdrawing and paying taxes on the entire IRA within 5 years of the original IRA owner's death, or start taking annual, taxable distributions by December 31 of the year following the owner's death.
Stretching an Inheritied IRA
The option to take annual withdrawals from an inherited IRA allows you to stretch and grow the value of your inheritance. Your minimum annual withdrawal amount is based on your life expectancy starting with the year following the IRA owner's death. For example, if you are 30 years old when the distributions start, the IRS Table 1, Single Life Expectancy chart gives a life expectancy of 53.3 years. For the first distribution, you must withdraw the IRA value divided by 53.3 or 1.88 percent of the account value. For the next year, the account value would be divided by 52.3 — taking one year off the life expectancy. With the stretch option, the IRA can continue to grow and you will recieve a larger distribution each year.
To set up the inherited IRA for annual distributions, you must transfer or roll the IRA proceeds to a designated beneficiary IRA, titled to show it is an inherited IRA. An IRA beneficiary does have the option to disclaim some or all of an inherited IRA to pass the IRA money without being taxed to the next generation. The younger beneficiaries can then use the stretch IRA technique with the IRA proceeds. If the IRA owner's estate paid estate taxes, those taxes can be used as a tax deduction against taxes due on a cashed-out IRA.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.