The tax consequences of an inherited individual retirement account depend on your relationship to the late account owner. If the owner was your spouse, you're in a different position than any other beneficiary. For non-spouses, the way you decide to receive these funds determines the taxes due. Taxation also depends on whether the IRA is a traditional or Roth account.
Spousal Inherited IRAs
If you inherited your spouse's IRA, you have several options, none of which need to result in paying taxes immediately. Only a spouse can retitle an inherited IRA in her own name, or roll it over into her own IRA. If the inherited account is a traditional IRA -- with contributions coming from pre-tax dollars -- you must start making mandatory withdrawals by the age of 70 1/2 and paying regular income taxes on the distributions. For an inherited Roth IRA - in which contributions were made with post-tax dollars -- there is no required age for taking withdrawals. Any withdrawals you do make are tax-free.
If you inherited the money from a parent, sibling or unrelated individual, you have two basic choices. You either can cash out the account and take a lump sum distribution, or retitle the account as an inherited IRA. The latter choice often makes more sense for tax purposes. The account is not retitled in your name, but reads "Deceased Person's Name (died Jan 1, 2014) for Your Name Here's benefit as beneficiary."
Inherited IRA Withdrawals
Even if you haven't reached the age of 59 1/2, the minimum age at which you can generally take IRA distributions without tax penalty, you can start making withdrawals. Such withdrawals from traditional IRAs are taxed as ordinary income. Inherited Roth IRA withdrawals are tax-free. You have the choice of withdrawing money annually, or withdrawing the entire amount of the IRA within five years of the death of the late account owner.
If you choose to take the entire amount of the IRA in one lump sum, you'll owe taxes on the distribution in the year you receive it. If it's a large amount, the tax bite can be severe, as the entire amount taken is taxed as ordinary income. Unless you're in a very low income bracket, that means a tax hit ranging from 25 to 39.6 percent of the proceeds as of 2014.
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