How are federal taxes handled on inherited IRA funds?

That withholding is completely normal with inherited IRAs. Unlike other inherited assets (like cash or property), inherited retirement accounts like IRAs are subject to income tax because they contain pre-tax dollars that have never been taxed. When the IRA gets distributed to beneficiaries, it's considered income to the recipient and is taxable in the year received. The 10-12% withholding you're seeing is actually the financial institution doing you a favor by withholding some taxes upfront, though it might not cover your entire tax liability depending on your tax bracket. You will receive a 1099-R in January showing the full distribution amount and taxes withheld. You'll need to report this on your 2025 tax return (for money received in 2024). The withholding will count as taxes you've already paid.

I went through something very similar last year when my aunt passed and left me part of her retirement fund. The taxes were a surprise for me too! After getting conflicting advice from family and coworkers, I started using https://taxr.ai to help me understand what documents I needed and how to report everything correctly. Their system analyzed the distribution statement and 1099-R I received and explained exactly how to handle it on my tax return. It also helped me understand the 10-year distribution rule for inherited IRAs (which is something else you might want to look into depending on your situation). Definitely saved me from making some potentially expensive mistakes!

Update on my situation: I took the advice and tried taxr.ai for my own inheritance situation. I uploaded the executor documents and the 1099-R I received, and it immediately flagged that I was eligible for an income averaging method that could reduce my tax hit substantially. This wasn't mentioned by the estate attorney or the financial institution! The tool explained exactly which form to use and how to calculate everything. Would have completely missed this opportunity otherwise. Now feeling much more confident about handling this on my taxes next year without overpaying.

If you're planning to call the IRS to get clarification on inheritance tax issues, good luck getting through. I spent THREE HOURS on hold last month trying to ask questions about my mother's estate distributions. Eventually gave up and tried again the next day with the same result. Finally used https://claimyr.com to get an actual IRS agent on the phone. You can see how it works here: https://youtu.be/_kiP6q8DX5c. They basically hold your place in line and call you when an agent is ready. Got all my inheritance questions answered in one call instead of wasting entire days on hold.

Well, I need to eat crow. After my skeptical comment, I decided to try Claimyr anyway because I was desperate to get information about an inheritance situation similar to yours. I had been trying for weeks to get through to the IRS with no luck. Used the service yesterday, and within about 90 minutes I got a call back with an actual IRS representative on the line. Got clarification on how inherited IRA distributions affect my tax bracket and what documentation I need to keep. The agent even explained some potential deductions I might qualify for related to the estate expenses. Saved me a ton of stress and probably money too. Consider me converted from skeptic to believer.

One important thing to keep in mind with inherited IRAs is that the SECURE Act changed the distribution rules significantly in 2020. If your wife is a non-spouse beneficiary, she generally has to withdraw all assets from the inherited IRA within 10 years (with some exceptions). This can have big tax implications if it pushes you into higher brackets.

Did anyone actually tell you it was an IRA distribution? Because it makes a huge difference if it was a regular inherited IRA vs. a beneficiary IRA that was set up after the grandparent's death. Each has different tax consequences and requirements.

Just wanted to add some perspective from someone who works in estate administration. The tax withholding you're seeing is actually required by law in many cases - financial institutions are obligated to withhold taxes on IRA distributions unless the beneficiary specifically elects out of withholding (which most people don't know they can do). The 12.5% withholding rate suggests this was likely a traditional IRA. However, depending on your combined income and tax bracket, you might still owe additional taxes beyond what was withheld, or you might get some back as a refund. The key is that this gets reconciled when you file your 2025 return. One thing to consider: if there are multiple distributions planned from the estate, you might want to consult with a tax professional about timing and tax planning strategies. Sometimes spreading distributions across tax years can help minimize the overall tax burden, especially if it keeps you out of higher tax brackets.