In many cases, you won't owe taxes on money you inherit. However, when you inherit a retirement account such as an individual retirement account (IRA) or a 401(k), disbursements from that account may be subject to federal income tax. The financial institution that manages the account sends a Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R) to you and the Internal Revenue Service (IRS) indicating how much of the money you have received may be taxable. You use the information on the Form 1099-R to report taxable distributions on your income tax return.
Taxes and Your Inheritance
There is no federal inheritance tax, and, for the most part, inherited funds are exempt from income tax. Some states, including Nebraska and Kentucky, impose an inheritance tax, but provide an exemption for close relatives of the deceased. Disbursements from an inherited retirement account are treated differently, however, when the plan participant made contributions to the account in the form of pretax income. If the plan participant had lived to withdraw funds from the account, that money would be taxable to the extent it came from pretax contributions. The funds retain their taxable nature when they are paid to you after the plan participant's death because no one has ever paid taxes on them.
Many types of retirement accounts that can be inherited permit plan participants to deposit pretax funds. These include qualified retirement plans such as 401(k)s, traditional IRAs, and Roth IRAs. Some of these plans also permit participants to invest posttax funds. To the extent that you receive payments from posttax funds, those payments should be exempt from income tax, although you are still required to report them on your income tax return.
The final piece of information to bear in mind about retirement accounts is that plan participants may owe the IRS early withdrawal penalties. For example, withdrawals from a 401(k) before age 59 ½ are subject to a 10 percent penalty, while funds in a Roth IRA must be held for five years or face a penalty. In most cases, these penalties don't apply to disbursements when these accounts are inherited.
Information on Form 1099-R
A plan participant who withdraws funds from a retirement account receives Form 1099-R for income tax reporting purposes. Similarly, when you receive distributions from an inherited retirement account, you receive a Form 1099-R. This form indicates the total amount of distributions you have received, the amount of tax withheld (if any), and possibly the taxable amount of distributions. Box 7, labeled "Distribution Code(s)," describes the nature of the distributions, indicating what type of account they come from and whether they may be subject to early withdrawal penalties. Some common distribution codes and their meanings include:
- "4" indicates that the distribution comes from a tax-deferred retirement account and is taxable but exempt from an early withdrawal penalty due to the death of the plan participant.
- "Q" means a qualified distribution from a Roth IRA that is neither taxable nor subject to an early withdrawal penalty because the five-year holding requirement has been satisfied.
- "T" denotes a potentially taxable distribution from a Roth IRA that is not subject to an early withdrawal penalty because of the plan participant's death.
You should always review Form 1099-R to be sure all the information it contains is accurate. Unfortunately, the form may indicate in box 2b that the account's custodian was unable to determine how much of the distributions you have received is taxable. In this situation, it is usually best to consult an attorney or tax professional to help you determine your tax liability.
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