Whether a spouse or non-spouse is named the beneficiary of an individual retirement account (IRA) when the IRA owner dies, the current tax law allows the inheritance, or the total sum in the account, to be accepted tax-free. Beneficiaries of the IRA can also withdraw from the account without penalty.
However, distributions from an inherited IRA are required. Remember that any voluntary or required minimum distribution (RMD) from the account is taxable. Taxation depends on the type of IRA involved and the beneficiary’s relationship to the deceased.
Spouses who inherit an IRA have more flexibility than non-spouse beneficiaries regarding when they must begin taking withdrawals and deplete the account. One of the important for non-spouse beneficiaries is that all money from the account must be withdrawn by Dec. 31, the 10th year after the original owner’s death.
Types of IRAs
A traditional IRA offers a tax deduction during the years contributions are made to the account. The contribution amount is used to reduce the person’s taxable income in the tax year for which the contribution was made. You can also make contributions that are not tax-deductible.
IRAs grow on a tax-deferred basis. This means any accumulated earnings and interest are not taxed. However, when the money is withdrawn as a distribution, the amounts are taxed at the individual’s income tax rate in the year of the withdrawal.
If the money is withdrawn before the age of 59½, there’s a 10% tax penalty imposed by the IRS and the distribution would be taxed at the owner’s income tax rate. If you inherit a traditional IRA to which both deductible and nondeductible contributions were made, part of each distribution is taxable.
A Roth IRA doesn’t offer an upfront tax deduction like traditional IRAs, but withdrawals from a Roth are tax-free in retirement. If you inherit a Roth IRA, it is completely tax-free if the Roth IRA was held for at least five years, starting Jan. 1 of the tax year for which the first Roth IRA contribution was made.
If you receive distributions from the Roth IRA before the end of the five-year holding period, they are tax-free to the extent that they represent a recovery of the owner’s contributions. However, any earnings or interest on the contribution amounts is taxable.
Required Minimum Distributions (RMDs)
The IRS has a minimum amount that accountholders must withdraw from an IRA and defined-contribution plans, such as 401(k) plans) each year. These mandatory withdrawals are called required minimum distributions. RMDs are designed to exhaust the funds in the account eventually. RMDs apply to traditional IRAs. Roth IRAs don’t require RMDs.
If you own a traditional IRA, you must begin your distributions when you reach age 73, a new age limit established by the SECURE Act 2,0, which is part of the Consolidated Appropriations Act of 2023. However, if you turned 72 before Jan. 1, 2023, you would have needed to begin taking RMDs at age 72, or 70½ if you hit that milestone before Jan. 1, 2020.
All RMD withdrawals are included in your taxable income except for any portion taxed earlier—say, if you contributed to the account with after-tax dollars.
If you fail to take your RMD, you can be subject to a 25% penalty on the amount you should have—but didn’t—withdraw. However, this penalty can be reduced to 10% if you take the missed distribution within the correction window. According to the Act, this window begins when the penalty is imposed. Usually, on Jan. 1 after the year, you failed to take a distribution. The window ends on the earliest of:
- The date the IRS mails you a notice of deficiency
- The date the IRS assesses the penalty
- The last day of the second taxable year after the penalty is imposed
If you take your RMD before the end of the correction window, your penalty will be reduced to 10%