Inherited IRA Taxes: 4 Key Rules That Can Change What You Owe

Two heirs can inherit nearly identical IRA balances and still face very different tax bills.

Inheriting an IRA can seem like a financial boost, but the important question is how much of that money you actually get to keep after taxes.

The answer depends on more than the account balance. Your state, your relationship to the deceased, the type of IRA involved, and when you withdraw the money can all affect the outcome.

That is why two beneficiaries who receive IRAs with the same value may still owe very different amounts. One person may have flexibility over withdrawals, while another may be required to empty the account within a fixed period. State tax rules can also make a difference.

Here is a closer look at the main factors that can shape the tax hit on an inherited IRA.

Inherited IRA tax rules

To estimate what you will keep from an inherited IRA, it helps to begin with the basic tax framework.

In general, inheriting an IRA is not a taxable event for federal income tax purposes. Taxes usually depend on the type of IRA and the way distributions are taken.

State taxes can also change the amount you owe.

Things to keep in mind:

• Distributions from an inherited traditional IRA are usually taxed as ordinary income at the federal level.
• Qualified distributions from an inherited Roth IRA are generally tax-free.
• The 10% early withdrawal penalty often applies when IRA owners take money out before age 59½, but it generally does not apply to inherited IRA distributions, no matter your age.
• Timing matters too. Many beneficiaries face distribution deadlines, and missing a required withdrawal can trigger a 25% federal IRS penalty on the amount not taken.

Those are federal rules, though. State tax laws may differ, sometimes significantly.

Some states tax IRA withdrawals based on where you live, while a few impose inheritance taxes based on where the deceased person lived.

Together, those rules can affect both when you must withdraw money and how much tax you pay. These four questions are the most important ones to ask.

1. Where do you live, and where did the account owner live?

When state taxes are involved, two questions can influence how much of a traditional inherited IRA you keep.

First, does your state tax IRA withdrawals as income?

Second, did the person who left you the account live in a state that imposes an inheritance tax?

Five states currently impose inheritance taxes: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Whether you owe that tax generally depends on where the deceased person lived or owned taxable property and on your relationship to them.

Estate taxes are different. In that case, the estate usually pays before assets are distributed to heirs. Twelve states and the District of Columbia impose estate taxes. Maryland is the only state that imposes both estate and inheritance taxes.

Note: At the federal level, taxable distributions from an inherited traditional IRA generally count as ordinary income.

An example: Suppose you live in Florida and inherit a traditional IRA from someone who lived in Pennsylvania.

Florida does not tax individual income, so it generally would not tax your IRA withdrawals as income. Pennsylvania also generally exempts IRA distributions paid to a designated beneficiary.

But Pennsylvania may impose inheritance tax on the IRA balance if the deceased owner was age 59½ or older at death, or was disabled at death regardless of age.

When Pennsylvania inheritance tax applies, the rate depends on your relationship to the deceased:

• Surviving spouse: 0%
• Direct descendants and other lineal heirs: 4.5%
• Siblings: 12%
• Most other beneficiaries, including friends: 15%

This can get complicated, and the example is simplified.

The takeaway: If you inherit a traditional IRA, consider both state income tax on withdrawals and whether inheritance or estate taxes may apply. The rules vary by state, and the type of tax can meaningfully affect what you keep.

2. What was your relationship to the person who left you the IRA?

The rules can change depending on whether you inherited the account from a spouse, parent, other relative, or someone unrelated.

A surviving spouse generally has more options than most other beneficiaries. Depending on the situation, a spouse may be able to treat the inherited IRA as their own or keep it as an inherited account. Those choices affect the distribution rules and can change when withdrawals are required.

An adult child who inherits a parent's IRA generally cannot simply treat it as their own. Instead, beneficiary distribution rules usually apply.

• For many non-spouse beneficiaries who inherit from someone who died after 2019, the account generally must be emptied by December 31 of the tenth year after the year of the original owner's death.
• Exceptions generally apply to Eligible Designated Beneficiaries (EDBs), including surviving spouses, the owner's minor children until they reach the age of majority, disabled or chronically ill individuals, and beneficiaries who are not more than ten years younger than the deceased owner.
• The exact requirements depend on the beneficiary category and the circumstances surrounding the owner's death.

It is also important to note that the ten-year rule does not always mean you can wait until the last year to withdraw everything. Depending on the rules that apply, annual required minimum distributions may still be required.

Your relationship to the deceased also does not determine the federal income tax rate by itself. Instead, it determines which distribution rules apply and how much flexibility you have over timing.

The takeaway: Know your beneficiary category before planning withdrawals. Your relationship to the deceased can determine when the money must come out, while your taxable income generally determines the federal rate you pay.

3. What kind of IRA did you inherit?

Inherited IRAs are not all taxed the same way. One of the biggest differences is whether the account is a traditional IRA or a Roth IRA.

• With a traditional IRA, contributions may have received favorable tax treatment when the original owner made them.
• As a result, taxable withdrawals generally count as ordinary income for the beneficiary in the year the money is distributed.
• If you inherit a traditional IRA and take a large distribution, the added income could push part of your earnings into a higher federal tax bracket.

Note: If the original owner made nondeductible contributions, part of the account may represent after-tax money. In that case, not every dollar distributed may be taxable.

A Roth IRA can work differently. Qualified Roth IRA distributions to beneficiaries are generally tax-free if the requirements are met. The five-year rule matters when determining whether a distribution qualifies for tax-free treatment.

Tax-free, however, does not always mean the account can sit untouched forever. Beneficiaries generally still face distribution deadlines, though the details depend on the beneficiary and the circumstances.

The difference can be significant. Someone who inherits a traditional IRA may need to plan for income tax on withdrawals, while someone who inherits a Roth IRA may receive qualified distributions without paying federal income tax.

The takeaway: Before estimating your tax bill, determine whether the account is traditional or Roth. The type of IRA can have a major effect on how withdrawals are taxed.

4. When do you take the money out?

Once you understand state residency, beneficiary status, and the type of IRA, one more question remains: when should you withdraw the money?

For many traditional IRA beneficiaries, timing can affect the tax bill.

For example, if you inherit a traditional IRA worth $300,000 and also earn a substantial salary, taking the full amount in one year could add a large taxable sum on top of your regular income. Depending on your circumstances, some of that income could fall into a higher marginal federal bracket.

Spreading withdrawals over several years may help manage that. Still, delaying distributions is not always the best choice, because you must follow the applicable deadlines and any required minimum distributions.

• For many non-spouse beneficiaries subject to the ten-year rule, the account must be fully distributed by the end of the tenth year after the original owner's death.
• Depending on when the owner died and whether required distributions had already begun, annual withdrawals may also be required during that period.

For instance, if an IRA owner dies and the beneficiary is subject to the standard ten-year rule, the account generally must be emptied by December 31 of the tenth year after death. Other beneficiary categories may follow different rules.

A Roth IRA may offer different planning flexibility because qualified withdrawals are generally tax-free, but distribution deadlines can still apply.

The key is to look at the inherited IRA together with your other income, your expected cash needs, and the deadlines that govern the account. A strategy that works for someone near retirement may not fit a beneficiary in a high-earning phase of life.

The takeaway: The amount you withdraw in a given year can affect the income tax you owe. The challenge is balancing tax planning with the rules on how quickly the account must be emptied.

Inherited IRA taxes: the bottom line

Inheriting an IRA does not mean you have to take the money immediately. But waiting as long as possible is not always the smartest move either.

Before taking a distribution, find out when the account must be emptied and whether annual withdrawals are required. Then think about how a payout would affect your taxable income in the year you receive it. In some cases, coordinating withdrawals with your other income and expenses over several years can help reduce the tax burden.

Also remember that moving into a higher tax bracket does not mean all of your income is taxed at that higher rate. Federal income taxes are marginal, so only the income that falls within the higher bracket is taxed at that rate.

If the account is large, or if you are unsure how these rules apply, consider speaking with a tax professional before deciding. The goal is to make informed choices that comply with the rules and work for your finances over the entire period you manage the inheritance.