Tax Treatment for Nonfamily IRA Beneficiaries

by Leslie McClintock

The Internal Revenue Service (IRS) grants favorable tax treatment to individual retirement arrangements (IRAs) inherited by surviving spouses. When this occurs, the spouse has the option of rolling her spouse's IRA into her own, treating the IRA as her own or taking distributions under a more favorable actuarial table. Nonspouses do not have this benefit, however.

Inheriting a Traditional IRA

Whether you are a family member or not a family member of the original IRA owner, if you inherit a traditional IRA from a non-spouse, you will need to consider the tax ramifications. You can not make an election to be treated as the IRA owner. You can, however, execute a tax-free trustee to trustee transfer of the assets to a different fund or investment company, if you choose. The deceased person's name must remain on the account, though the fund company can change the Social Security number on the account to that of the beneficiary.

Required Minimum Distributions

Anyone who inherits a traditional IRA from someone who was not a spouse must begin taking required minimum distributions (RMDs) in the year after the original owner died. If you were the designated beneficiary on the account, however, you can maximize the benefit of tax deferral by spreading your distributions out over your natural life expectancy, according to the IRS's mortality tables, rather than that of the original owner, if that schedule is more favorable to you. You must take the required distribution by the end of the calendar year, or the IRS may charge a penalty of 50 percent of the distribution required but not taken. You must declare the distribution as ordinary income, and pay income taxes on the amount withdrawn. If the original owner did not receive his RMD for the year in which he died, the beneficiary must take it in the same year or as soon as practicable in the next year.

Inherited Roth IRAs

Inherited Roth IRAs sometimes receive more favorable tax treatment than inherited IRA accounts. This is because the original owner already paid taxes on the money in the account when it was originally contributed. However, if the Roth IRA is inherited by a beneficiary who was not a spouse, and the assets had not been held in the account at least five years prior to distribution, the nonspouse beneficiary must take a required minimum distribution based on the IRS's actuarial tables, and pay income taxes on it. The usual 10 percent penalty on distributions to those aged 59 1/2 do not apply in this case, however. If the five-year test has been met, there is no income tax due on required minimum distributions from Roth IRAs. However, you cannot let the money compound tax-free in an inherited Roth IRA indefinitely.

When There Is No Designated Beneficiary

If there was no beneficiary designated on the account, then the IRA assets are distributed under probate law, rather than contract law. In this case, the option to take distributions over the heir's remaining life expectancy does not apply. The recipient must empty the Roth IRA account by the end of the fifth year following the death of the original account owner.

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