How to Avoid Paying Taxes on an Inherited IRA

Well, it’s a common question: How to avoid paying taxes on an inherited IRA? However, the answer largely depends on what type of IRA you inherit. This article explains the basic rules for inherited IRAs (aka beneficiary IRAs) to help you understand how they work and how different beneficiaries can treat these funds.

Is Your Inherited IRA a Traditional or Roth Account?

In terms of avoiding paying taxes on an inherited IRA, the more accurate question is: Is the inherited IRA a pre-tax or post-tax account? This makes a huge difference. Traditional IRAs and Roth IRAs don’t have the same tax benefits because their contributions are treated differently. And some employer plans offer both pre- and post-tax contributions, which impact the tax liability of those funds when distributed.

The information below applies to conventional IRAs as well as self-directed IRAs.

Inherited Roth IRAs

The original account owner made contributions to a Roth IRA with earnings that were already taxed. The greatest benefit, and the reason this account is a favorite, is that income grows tax free in the account thanks to those post-tax contributions.

This means all distributions in retirement for the original account owner are tax free—including distributions of investment earnings. Beneficiaries also enjoy this benefit, making this account a powerful estate-planning tool for leaving funds to loved ones.

Inherited Roth IRA Distribution Rules

The rules for taking distributions from inherited accounts are the same as the rules original account owners must follow:A family hiking through the woods happily, because they know how to handle taxes on an inherited IRA.

    • Distributions of contributions can be taken at any time.

    • The original account must be five years old before distributions of income are tax free.

    • If you take distributions of earnings before you turn 59 ½, you incur a 10 percent early-withdrawal penalty and tax on those funds.

Spouses and non-spouses have different options for handling inherited Roth funds.

    • Spouses can roll these funds into an existing or new Roth IRA in their name and treat the funds as their own.

    • Non-spouse beneficiaries must deplete all inherited Roth IRA funds within 10 years of the original account owner’s death.

    • The above distribution rules for Roth IRAs apply to spouse and non-spouse beneficiaries.

Inherited Traditional IRAs

Original account owners made contributions to traditional IRAs with pre-tax dollars. Often, contributions constitute a tax deduction for the tax years when those contributions are made (a benefit Roth IRAs don’t offer).

However, all distributions taken by the original account owner in retirement are taxed as ordinary income in the year the withdrawals are made. Beneficiaries of traditional IRAs must also pay taxes when they take distributions from the account.

Inherited Traditional IRA Distribution Rules

Again, the rules differ for spouse and non-spouse beneficiaries.

    • Spouses can rollover funds from an inherited traditional IRA into an existing or new traditional IRA in their name and treat the inherited funds as their own. This allows them to delay paying taxes until they reach retirement age and begin taking required minimum distributions (RMDs).

    • Surviving spouses also have the option to open a new inherited IRA in their name and begin taking annual distributions immediately. These RMDs are calculated based on the surviving spouse’s life expectancy. The RMDs are taxed as ordinary income in the year they are withdrawn.

    • Non-spouse beneficiaries must roll inherited funds into a traditional inherited IRA. Annual distributions are not required; beneficiaries can withdraw funds one year and not the next. However, beneficiaries must withdraw all funds from the account by the end of the tenth year after the original account owner’s death. Distributions are taxed as ordinary income in the year they are taken.

    • Spouses and non-spouse beneficiaries both have the option to take a lump-sum distribution of all funds. In this case, tax is owed on distributed funds in the year it’s taken.

Final Words on Paying Taxes on an Inherited IRA

This article provides the basic inherited IRA distribution rules to answer the question, “How to avoid paying taxes on an inherited IRA.” Rules vary depending on what type of account you inherit and whether you are a spouse, non-spouse, or an eligible beneficiary.

The IRS inherited IRA rules for eligible beneficiaries differ from those for spouses and non-spouse beneficiaries. Eligible beneficiaries include minor children, disabled and/or chronically ill beneficiaries, and beneficiaries who are not over 10 years younger than the original account owner. If you fall into this category, seek appropriate advice from a tax professional to navigate distributions.

Additionally, there are different rules for beneficiary accounts that accept both pre-tax and post-tax contributions. For example, 401(k)s, SEP IRAs, and SIMPLE IRAs have both pre-tax contribution and post-tax Roth contribution components. Determining which distributions are taxed vs. those that are not taxed is complex. Consult with your tax professional to help you determine how to proceed with distributions.

Additional resources on inheriting an IRA:

Inherited IRA Distribution Rules: Webinar Recap

Inherited IRA Rules: 7 Things All Beneficiaries Must Know

 

 

About Scott Maurer

Scott Maurer, Vice President of Sales for Advanta IRA, is a recognized expert in the field of self-directed IRAs. With a law degree from the University of Florida and as a designated Certified IRA Services Professional (CISP), Scott’s keen understanding of rules and regulations fuels his passion to educate others on the power of investing in alternative assets using self-directed IRAs. Scott is a frequent guest on retirement and investing webinars and podcasts, and he has shown thousands of individuals how to achieve financial freedom by teaching them how to use their retirement funds to invest in private placements, real estate, private lending, and more. Throughout his two decades in the industry, he has watched numerous unique investments unfold, giving him great perspective of what is possible when people take control of their retirement funds and investing decisions.