Taxes on a Decedent IRA

There’s good news for heirs who receive an individual retirement arrangement (IRA) as part of their inheritance: As with all other forms of inherited property, the deceased’s estate paid any applicable estate taxes associated with the funds before the heir received the IRA, so it doesn’t need to be reported on income taxes. The bad news? The Internal Revenue Service (IRS) governs inherited IRAs with a different set of rules, so the heir must handle his inherited retirement assets appropriately or face stiff penalties.

Spouse as Heir

Similarly to estate-tax exemptions for spouses, the IRS provides married couples more leeway when dealing with inherited IRA. A spouse who becomes the beneficiary of a decedent IRA may treat the account as if she was the primary beneficiary, leaving all the funds in the IRA until she reaches retirement age, 59 1/2, and must begin receiving distributions when she reaches 70 1/2 as with traditional IRAs. She’s taxed at normal income tax rates when she receives distributions, but owes no other taxes on the decedent IRA.

Other Spouse Benefits

Because the IRS treats a spouse’s inherited IRA essentially as her own, she enjoys other asset-management options not available to other heirs. A spouse may roll her inherited IRA into her primary IRA. She may also choose to transfer other inherited assets into the decedent IRA, stretching out the amount of time before she depletes the account making minimum required distributions when she turns 70 1/2, allowing assets to grow within a tax-deferred account for as long as possible. She may also choose to waive her claim to the IRA within nine months of her spouse’s death, allowing it to pass to other heirs.

Non-Spouse as Heir

When anyone other than a spouse inherits an IRA, the tax rules that govern it are much more complicated. The IRS requires the heir to begin taking required minimum distributions based on his expected lifespan, as determined by IRS actuarial tables, by December 31 of the year following the original IRA beneficiary’s death. The heir must take a minimum distribution each year until the heir exhausts the IRA’s balance. If the heir fails to make a required minimum distribution, the IRS taxes the amount not withdrawn at a 50 percent rate on the heir’s income taxes. Heirs may receive more than the required minimum distribution at any time they choose. Heirs who receive required distributions pay income taxes on the amount received, but distributions from decedent IRAs aren’t subject to the 10 percent early withdrawal excise tax if the heir is younger than minimum retirement age.

Five-Year Option

Non-spouses who inherit an IRA from a person who hadn’t begun to receive distributions from it may opt to receive distributions over a five-year period that exhausts the IRA’s balance. The distributions must be completed by December 31 six years after the original beneficiary died. The distributions don’t need to be made evenly as long as the IRA closes by the required date. The IRS taxes these distributions at the heir’s normal income rate, and early withdrawal penalties don’t apply.