Who Pays the Taxes on My IRA When I Die?

Consider the tax consequences when naming beneficiaries for your retirement accounts.
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A great benefit of saving with an individual retirement account is that taxes on the earnings and gains are deferred until you withdraw money in your retirement years. The tax rules are designed so the money must come out of your IRA at some point and be taxed. If you die, the beneficiaries of your retirement account eventually must pay the taxes. You can use different strategies to minimize the tax bite and maximize the money your heirs get to keep.

Types of IRAs and Tax Basis Possibilities

The typical use of a traditional IRA is to make annual tax-deductible contributions. In this case, the entire amount of the account value -- contributions and gains -- would be taxable if they were withdrawn. You can make nondeductible contributions, which count as after-tax deposits, and those amounts can be withdrawn with no tax liability. With a Roth IRA, for example, contributions are always from after-tax money, and the earnings grow tax free. With a Roth IRA, neither you nor your beneficiaries would be liable for any taxes on the account.

Spouses Can Let the Money Grow

If you leave your IRA to your spouse, she can choose to retitle the IRA to her name and treat it as her own. This means no taxes would be due until she removes the money in her retirement years. Your spouse beneficiary can leave the money in the account to grow tax deferred until minimum annual withdrawals must start at age 70 1/2.

Nonspouse Heirs Are Required to Withdraw the Money

If your IRA beneficiary is not a spouse, the entire inherited IRA balance must be withdrawn by a certain time, and taxes will be due on the withdrawals. If lump sum withdrawals are selected, the full amount of the IRA must be cashed out by the end of the fifth year after you die. This means the tax bill can be deferred until five years after you die, or withdrawals can be made in any of the five years to spread out the tax bill.

Stretch Option Lets Most of Your IRA Continue to Grow

A nonspouse beneficiary could instead elect a "stretch IRA" withdrawal option. The beneficiary tells the IRA custodian to set up annual withdrawals based on the beneficiary's age at the time the IRA was inherited. With this option, a small percentage of the IRA will be paid out and taxed each year, and the remaining balance continues to grow tax-deferred. This withdrawal method must be selected within one year of your death.

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