When you invest in an individual retirement account – an IRA – you are investing your capital in a tax-advantaged account earmarked for use during retirement. An IRA helps you grow your nest egg in a way that would not otherwise be possible, due to the enormous tax savings realized in this type of account.
If you do not use all of your funds before you pass away, you can will the IRA to your beneficiaries. If you are planning to leave all or part of your individual retirement account to your heirs, it is important to understand the tax treatment of inherited IRA accounts.
How your IRA is taxed will depend on which type of fund you own. There are two types of individual retirement accounts that you can leave to your heirs: a traditional IRA which is funded with pre-tax contributions, and a Roth IRA which is funded with after-tax contributions.
Tax Treatment Of Inherited IRA Accounts: Traditional IRAs
When you leave behind a traditional IRA, the IRA is taxed at your beneficiaries’ ordinary income rate, unless your spouse is the heir. Your spouse may elect to treat the IRA as their own, or roll it over into their individual retirement account.
Your spouse can also elect to treat themselves as the beneficiary of the IRA, in which case the rules for non-spousal beneficiaries apply. A non-spousal beneficiary is not entitled to claim the IRA as their own, and must open a beneficiary IRA, which can not be added to or rolled over.
Tax Treatment Of Inherited IRA Accounts: Roth IRAs
A Roth IRA is funded with after-tax dollars, and therefore beneficiaries will be able to take distributions tax-free. An inherited Roth IRA is exempt from income tax, as distributions from a Roth are tax-free.
Of the two types of IRAs, a Roth IRA is the most beneficial to heirs, as the funds are distributed tax and penalty free. This means that the inheritance will not add to your heirs’ gross income, and not increase their tax rate.
Inherited IRA Distribution: Lump Sum Or Annuity Payments?
It is a common misconception that when you inherit an inherited IRA distribution must be in a lump-sum payment. In reality, distributions may be taken over time using a withdrawal strategy called a stretch IRA.
A stretch IRA is an annuity contract whereas the IRA’s distributions are spread out over the life of the beneficiary in order to lessen the tax burden by spreading tax liability out over time.
How distributions are made is an important decision that should be discussed with your financial adviser. If you use online broker ETrade, you have access to top financial professionals that can assist you in deciding what is best for your situation.
Inherited IRA Distribution: Important Considerations
If you know that you will not be utilizing all or part of your traditional individual retirement account, consider rolling your IRA over to a Roth IRA, so your heirs can benefit fully from their inherited IRA distribution.
You can also consider using a stretch IRA by buying an annuity inside the IRA, in order to give your heirs the option of stretching payments out over time, instead of taking a lump sum payment.