An individual retirement account doesn't end with the owner's death. Instead, the account and its tax benefits pass to the designated beneficiary. When you inherit an IRA, the money is still tax-sheltered. Until you start taking distributions, you don't have to pay taxes on any of the gains.
The Internal Revenue Service counts taxable withdrawals from an inherited IRA as ordinary income, just like the interest you earn on your checking or savings account. No matter how you or the person you inherited the account from invested the money in the IRA, the distribution won't ever qualify as long-term capital gains income. If you're in a higher tax bracket, you won't get the benefit of the lower capital gains rates.
Taxable or Nontaxable
Depending on which type of IRA you inherit, you might not have to share any of the money you cash out with Uncle Sam. Withdrawals from traditional IRAs are always taxable unless the original owner made nondeductible contributions. If so, you divvy up your distributions between the tax-free nondeductible contributions and the taxable remainder of the account. Money withdrawn from an inherited Roth IRA is tax-free if the previous owner held the account for five years or more before dying. If a Roth was held for less than five years, you get the contributions in the account tax-free, but when you eventually take out the earnings, you have to pay taxes.
Deduction for Estate Taxes
If the inherited IRA increased the original owner's estate tax bill, you get a tax deduction for that amount when you take out the money. Let's say the IRA increased the previous owner's estate tax bill by $15,000. If you take out 20 percent of the IRA, you get to deduct $3,000 from your taxes because you're reporting 20 percent of the income that year. However, if there wasn't any estate tax paid because the estate was too small, you don't get any tax deduction.
As an IRA beneficiary, you generally have to take out a certain amount of money each year or empty the account within five years. If you're the surviving spouse, you have additional options -- including treating the IRA as your own if you are the sole beneficiary -- and can take unlimited withdrawals from the IRA. If you elect to treat it as your own, you are not required to take required distributions as a beneficiary. However, you will still have to take required minimum withdrawals based on your own age. If you don't take out your required amount, you owe Uncle Sam a tax penalty of 50 percent of the amount you should have withdrawn. For example, say you were supposed to take out $18,000 by the end of the year. If you only took out $4,000, you owe an extra $7,000 on your taxes for the year because you failed to withdraw $14,000.
- Ryan McVay/Photodisc/Getty Images