Inheritance of a Traditional or Roth IRA

by Michael Keenan
Inherited IRA distributions must be reported on your income tax return.

Inherited IRA distributions must be reported on your income tax return.

Comstock/Comstock/Getty Images

If you’ve inherited an individual retirement arrangement, or IRA, it comes with restrictions on when the money must be distributed from the account. Failure to distribute the correct amounts in the correct years carries a stiff penalty – 50 percent of the amount not withdrawn. Knowing the rules will help you maximize the tax-free growth offered by the IRA while avoiding income tax penalties.

Five-Year Rule

One way you can satisfy the required distributions from an inherited IRA is to remove the entire amount from the account by the end of the fifth year from the date you inherited the account. For example, if you inherit the IRA in 2012, you would have to distribute the entire amount before the end of 2017 to avoid penalties. If you elect this method, you do not have to take any distributions from the account until the end of the fifth year. If you inherited an IRA in 2008 or earlier, minimum required distributions were suspended in 2009, which means you have an extra year to empty the account. Thus, if you inherited the IRA in 2008, you have until the end of 2014 to distribute the entire amount.

Annual Minimum Distribution Method

If you would prefer to leave more of the money in the IRA for a longer time, you can elect to take annual minimum distributions to satisfy the distribution requirement. The annual amount is determined by the value of the account at the end of the previous calendar year and your life expectancy or that of the decedent as determined by the single life expectancy table published by the IRS. If the decedent died before required minimum distributions started, you use your life expectancy. If the decedent had already started taking minimum distributions, use the longer of your life expectancy or the decedent’s life expectancy had he not died. You must continue to take the required minimum distributions until the IRA is empty. You can take more than the required minimum distribution each year, and you don't have to empty the account within five years if you choose this method.

Special Option for Spouses

If the decedent is your spouse, you have the option of treating the IRA as if it were your own rather than having to take required distributions as a beneficiary. You must still take minimum distributions from the account when required by your age, though. For example, if your husband died at age 75 and you are only 68, and you elected to treat the IRA as your own, you would not have to take required minimum distributions until you turn 70 1/2. Once you treat the account as your own, however, you no longer qualify for the exemption from the early withdrawal penalty granted to a beneficiary. If you prefer, you can use either the five-year rule or the annual minimum required distributions.

Taxability of Distributions

The taxability of distributions from an inherited IRA depends on the type of account, the age of the account and whether the decedent had a basis in the account. “Basis” refers to the total amount of tax-free contributions made to the account. All contributions to a Roth IRA are after-tax while most contributions to a traditional IRA are pre-tax contributions. Distributions from Roth IRAs should be reported to you annually on Form 1099-R, and box 7 should contain either a “Q” or a “T.” If a “Q” appears in box 7, it means the account has been open for five years and you are receiving the distribution as a beneficiary, so the entire distribution is tax-free. If a “T” is reported in box 7, it means the account has not been open for at least five years, so the return of basis is tax-free but any earnings distributed are taxable. If a “4” appears in box 7, it denotes a distribution from a traditional IRA. These distributions are entirely taxable unless the decedent made nondeductible contributions to the account. In this case, the distribution is prorated between the taxable and nontaxable portions. For example, if at the time of the distribution the account is 30 percent basis and 70 percent earnings, 30 percent of the distribution is tax-free.