Taxable Income Inheritance vs. Retirement

by Lisa Bigelow

The Internal Revenue Service (IRS), as well as state and local governments, tax individuals and businesses for a variety of purposes. Two of the most common taxes are for retirement income and some types of inheritance income. Where you live and what type of income you receive affects how much tax you'll pay, if any.

Inheritance Taxes

The federal government does not impose an inheritance tax on heirs for most types of inheritance income. Instead, it taxes the deceased's estate, but only if the estate is valued over $5 million dollars as of the time of publication. Since most estates are worth much less than $5 million dollars, most estates won't have to pay estate tax; if the estate is worth more than this amount, then how much tax the estate pays depends upon how much the estate is worth and the date the decedent passed. Many states follow the federal model, while others impose estate taxes at less than $5 million dollars; contact a tax professional who's familiar with your state's laws to find out what rules apply to you.

Retirement Beneficiaries

There are two notable exceptions to the "no inheritance tax" rule. If you are the beneficiary of an individual retirement arrangement (IRA) or a 401(k) -- or other employer-sponsored retirement account -- then the distributions you receive from the decedent's account are taxed at your current income tax rate. However, if you're the spouse of the decedent, then you may be able to roll the account over into your own personal account, thereby deferring the income taxes until you're ready to retire. Check with the plan sponsor, but IRS rules state that beneficiaries of these accounts must take distributions, although you can spread out the distributions over your life expectancy to minimize the tax impact. Also, remember that your state may tax your retirement, although many don't. Some have no income tax at all.

Retirement Income Taxes

People who contribute to tax-advantaged investment plans, such as the 401(k), 403(b) and IRA accounts, anticipate taking distributions after age 59 1/2. Before you begin taking distributions, your investments accumulate tax-free. You're only taxed on what you withdraw after this age. You must begin taking distributions by age 70 1/2. The idea is that your income tax bracket should be lower, assuming you're no longer working. In some circumstances, you may be able to take out retirement funds from these accounts before age 59 1/2. Other early distributions incur a penalty.

Taking Retirement Funds Early

Taking retirement funds out of a sponsored account early is a dangerous proposition. Not only do you miss out on whatever future appreciation may occur, the IRS levies a mandatory 10 percent penalty plus a 20 percent income tax on every unsanctioned early withdrawal; it does allow withdrawals for certain approved reasons, however. Your plan provider may also penalize you. In addition, the distribution will be added to your annual income and taxed at your current income tax rate. The potential exists for some owners who take early withdrawals to lose up to 50 percent of the distribution in taxes, so consider carefully before pursuing this option.

About the Author

Lisa Bigelow is an independent writer with prior professional experience in the finance and fitness industries. She also writes a well-regarded political commentary column published in Fairfield, New Haven and Westchester counties in the New York City metro area.