Beneficiaries of individual retirement accounts (IRAs) typically receive the same tax treatment from the Internal Revenue Service as original owners of IRAs. Taxation rules for traditional IRAs and Roth IRA vary. Beneficiaries of traditional IRAs typically pay income-tax rates on distributions, while beneficiaries of Roth IRAs often pay no taxes on withdrawals. The taxes your IRA beneficiary must pay also depends on the total size of the estate.
IRS IRA Withdrawal Regulations
If you withdraw funds from your IRA before the age of 59 1/2, you may face a penalty of up to 10 percent. However, the IRS allows two exceptions to the early withdrawal rule. You can make penalty free early withdrawals if you need money due to a disability. If you die, your beneficiary can also make penalty-free withdrawals, regardless of age.
Required Minimum Distributions
The IRS requires you to withdraw annual required minimum distributions (RMDs) from traditional IRAs after you reach the age of 70 1/2, or face penalties. However, the IRS does not require you to make RMDs with Roth IRAs. If you die, your beneficiary has the option of withdrawing all funds from the IRA in a lump sum, or receiving distributions over her lifetime. If you were already withdrawing RMDs, and your spouse decides to take lifetime distributions, she must continue to withdraw RMDs, regardless of her age. However, if she rolls over the IRA funds into her own traditional or Roth IRA, or a new IRA, she can make RMD withdrawals based on her own age. If she is younger than the RMD age, depositing the funds in another IRA can delay distributions, allowing the funds to earn more money.
Traditional IRA Taxation
Traditional IRS are tax-deferred, which means you do not have to pay taxes on your funds until you make a withdrawal. The IRS applies the same rules to the beneficiary of your IRA funds after you die. When your beneficiary withdraws funds, he must pay taxes according to his normal income tax rate.
Roth IRA Taxation
If you have a Roth IRA, you can typically make tax-free withdrawals from your account after the age of 59 1/2, and after you have held the account for at least five years. An exception to this rule may apply if your Roth IRA includes taxable funds that you contributed when converting a traditional IRA to an Roth IRA. In such cases, you can first make tax-free withdrawals from after-tax contributions, followed by withdrawals from taxable funds. In the event of your death, the same rules apply to your beneficiary, but without the age restriction.
The beneficiary of your IRA may face estate-tax requirements if you have a large estate. As of 2011, estate taxes apply to estates with total assets that exceed $5 million. If the amount of your IRA places your beneficiary at risk of estate-tax requirements, you can consider creating a trust to be the beneficiary. This allows you to name the same person as the beneficiary of the trust, while removing the IRA funds from your estate.
- Fidelity: IRA Withdrawals-IRA Tax Implications
- Kiplinger; Taxes on 401(k) and IRA Withdrawals; Kimberly Lankford; May 2008
- IRS: Retirement Plans FAQs Regarding Required Minimum Distributions
- TurboTax: Estates and Trusts
- IRS: Estate Tax
- The Wall Street Journal; Trust as Beneficiary of IRA Is a Popular Strategy; Kelly Greene; August 2009