Individual retirement accounts, or IRAs, can be passed on to heirs like any other investments. If you inherit an IRA from a parent, spouse or other relative, you may owe taxes on any amounts you receive from the IRA. The IRS sets minimum amounts you must withdraw from the IRA, depending on your age and your relation to the person who left the IRA to you. The tax rate you pay depends on your tax situation. IRA withdrawals are considered part of your adjusted gross income and not taxed separately.
Relationship to IRA Holder
If you inherit an IRA from a spouse, the IRS allows you to treat the IRA as your own. You can designate yourself as the new holder of the IRA, make contributions to it as you would any other IRA, and leave the money to accumulate until your retirement. You don't pay taxes on the money in the IRA until you withdraw it. At that time, the amount of taxes you'll pay depends on how much you withdraw, your adjusted gross income and the tax bracket into which you fall, and tax rules at the time. If you inherit the IRA from a parent or anyone else, you can't treat the IRA as your own and must take distributions from the account.
When you inherit an IRA, you have the option of withdrawing all the money at once and using it for whatever purpose you wish, such as a trip to Tahiti or a new car. However, the amount you withdraw increases your adjusted gross income and you'll owe income tax on the total amount. This could end up costing you a significant sum, depending on the size of the IRA and the tax bracket into which you fall. If a lump sum doesn't make sense tax-wise, you have two other options.
You must withdraw money from an IRA you inherit from someone other than your spouse by the fifth year after your inheritance. If you inherit an IRA in 2011, you must begin withdrawing money from the account by 2016. But if you decide to choose this option, you must withdraw all the money from the account by 2016. Failing to make the required withdrawal will result in tax penalties.
The IRA also allows you to withdraw smaller amounts from the inherited IRA over a number of years. How many years depends on your age and the age of the person from whom you inherited the IRA. If the original owner of the IRA died before he reached age 70 1/2, you figure distributions by taking your life expectancy, as listed on tables published by the Internal Revenue Service, by the total amount in the IRA that year. If you are 44 years old, your life expectancy, according to the IRS tables published in 2010, is another 39.8 years. Divide the value of the IRA by 39.8. The answer is the amount you need to withdraw each year. You'll pay taxes on this amount, according to your adjusted gross income and tax bracket. If the original owner of the IRA was older than 70 ½ when she died, use the average life expectancy for their age from the IRS tables. For example, an 84-year-old has a life expectancy listed at 8.1 years. Divide the value of the IRA by 8.1 and you'll compute the minimum withdrawal you must make from the IRA each year for the next 8.1 years. The amount you withdraw is added to your income and increases your taxes depending on your adjusted gross income and tax bracket.