An IRA is a great way to earn tax-free interest on your investments, but it can't last forever. When you inherit an IRA, you may have to see some of it drained off to pay the original owner's estate taxes. Before long, you'll have to start withdrawing the money and paying tax on it yourself.
Estate tax rates, as of 2013, run as high as 40 percent. The good news is, 99 percent of Americans don't have to pay them; estates worth less than $5.25 million are tax exempt. If someone leaves behind a big enough estate to owe the tax, the IRA becomes one of the estate's taxable assets. As the beneficiary, you can take a deduction for estate tax paid on the IRA, even if the executor pays with other funds. A 40 percent tax on a $500,000 IRA, for instance, would give you a $200,000 tax write-off.
In the year following the owner's death, you have to start taking required minimum distributions out of your inherited account. The IRS bases your RMD on the worth of the account divided by the number of years the IRS life-expectancy tables say you have left. If it's 50 years and a $200,000 account, for instance, you take out at least $4,000. Whatever you withdraw is taxable, unless the owner included after-tax contributions in his IRA. There's no tax on those.
Widows and Widowers
If the account owner was your spouse, you're in luck. Instead of starting withdrawals, you can keep the IRA open and even put your own money into it. Just like an IRA you opened yourself, you don't start RMDs until you turn 70 1/2. Instead, the money can sit and keep earning interest tax-free. If you take this option, though, you pay a 10 percent tax penalty on any withdrawals before you turn 59 1/2.
You have to take RMDs from a Roth IRA just like a traditional IRA. The big difference is that there's usually no tax on them. The exception is if you inherit an account that's been open less than five years. You can still withdraw the owner's contributions tax free, but you pay income tax on earnings. If the owner converted another account into a Roth less than five years ago, the converted funds are taxable too.
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