Tax Implications of Inherited IRAs - John R. Dundon II, Enrolled Agent
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Tax Implications of Inherited IRAs

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Tax Implications of Inherited IRAs

Taxpayers who inherit IRAs also inherit the decedent’s basis or amount invested in those IRAs, regardless of the relationship between the beneficiary and the decedent. Ideally, the decedent will have filed IRS Form 8606 (Nondeductible IRAs), showing the amount of basis in the IRA. Any remaining basis in the IRA shown on Form 8606 then becomes the beneficiary’s basis. However, if the decedent did not file Form 8606, the taxpayer has the same challenges as any IRA owner in demonstrating that he or she has basis in the IRA.

If the decedent had no basis in the IRA at the date of death, the beneficiary is taxed fully on distributions from the inherited IRA which must equal or exceed the Required Minimum Distribution (RMD). If the decedent did have basis in the IRA, the beneficiary must file Form 8606. The 1099-R issued by the payer should identify whether there is basis in the IRA.

Generally, there are several options for how to handle the inherited IRA, and the RMD rules differ for each option as follows:

1. Treat the account as your own IRA by designating yourself as the account owner. If you treat the IRA as your own, you will have to take RMDs if over 70 1/2. However, you may use your own life expectancy for the RMD calculation, so theoretically less will be withdrawn from the account with each distribution.

2. Roll the IRA into your own existing IRA or qualified plan subjecting yourself again to the RMD

3. Treat yourself as the beneficiary of the IRA instead of the owner and begin taking distributions over your life expectancy.

The basis and Fair Market Value (FMV) of an inherited IRA are kept separate from your basis and FMV in your own IRA. If you elect to treat the inherited IRA as your own, the inherited IRA could be aggregated with your other IRAs on Form 8606.

Beneficiaries must begin to take required distributions from the account by December 31 following the year of death. If the beneficiaries are nonresident aliens for U.S. tax purposes, the IRA trustee may need to withhold U.S. tax on the distributions.

If the owner of an IRA dies before reaching the required beginning date for RMDs, each beneficiary can take required minimum distributions based on their own life expectancy, or take a distribution of the entire account balance by December 31 of the calendar year that includes the fifth anniversary of the decedent’s death.

Unfortunately, according to IRC 4974 if an RMD is not taken, a hefty fifty-percent excise tax may be assessed. Penalties are reported on IRS Form 5329. The IRS however may waive the fifty-percent penalty if there was a reasonable cause for failing to take the distribution such as erroneous advice given, and steps to correct the error have been taken.

If there was a reasonable cause for failure to take the RMD, the taxpayers need not pay the fifty-percent excise tax when they file their tax returns. Form 5329 instructions direct the taxpayer to complete lines 50 and 51 and enter “RC” and the amount of waiver requested on the dotted line next to line 52. This amount should be subtracted from the total, with the tax paid on the remaining amount (line 53).