How Your Inherited IRA is Taxed

Couple inherited IRA Have you inherited an IRA? What type of IRA is it? Your answer will matter a lot when it comes to your tax bill. Inheriting a traditional IRA will have very different tax consequences than inheriting a Roth IRA.

Consider the following example. Let’s say Tom named his three children as beneficiaries of his three-million-dollar traditional IRA. He never made any nondeductible contributions. When his children take distributions from the traditional inherited IRA those distributions will be fully taxable, but not subject to penalty. What if Tom converted his traditional IRA to a Roth IRA more than five years ago? All distributions from the Roth IRA paid to his children would be tax and penalty free. That is a very different result.

Traditional IRA

If you were named the beneficiary of a traditional IRA, you will most likely face income tax consequences. This is because most funds in traditional IRAs are tax-deferred but not tax-free. Uncle Sam will eventually want his share. Distributions to beneficiaries will be taxable to the beneficiaries in the year taken. You can minimize the tax impact by using the stretch and taking distributions over the longest period of time the rules allow.

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