As Part of an Inheritance
Here's a morbid scenario. What if you save up a sizable nest egg in your IRA, but die in a tragic accident before you reach the magic age of 59 ½? It seems only fair that your spouse, children, ferret or other legal heirs could cash in your IRA. But will they have to pay income tax, or an early withdrawal penalty, if they want to collect their inheritance?
The bad news is that you're dead, but the good news is that your heirs are exempt from the 10 percent early withdrawal penalty [source: IRS]. As usual, there is some fine print when it comes to taxes. If you leave a traditional IRA to your heirs, they will most likely pay income tax on any withdrawals from the account, unless a portion of your contributions to the traditional IRA were non-tax-deductible. But if all of your contributions were pre-tax — which is common — then all distributions, even to your heirs, are taxed as income.
If you leave a Roth IRA to your heirs, they won't have to pay income tax on withdrawals unless the account is less than 5 years old. If you made the first contribution to the account less than five years before you pass on, then your heirs will have to pay income tax on any earnings or gains [source: IRS]. Also, if your spouse wants to roll your retirement funds into his or her own IRA, he or she will have to pay income tax on the rollover.