Inherited IRA and Capital Gains Tax: Do You Pay Capital Gains Rates?

The short answer is no. Inherited IRA distributions are taxed as ordinary income — at rates up to 37% — regardless of what the investments inside the account did. Understanding this distinction is one of the most consequential tax facts for anyone managing a large inherited IRA.

Why ordinary income — not capital gains — applies to IRA distributions

To understand why capital gains rates don't apply, you need to understand what an IRA is from a tax standpoint: a tax-deferred wrapper for pre-tax dollars.

When your parent contributed to their traditional IRA, they received a tax deduction. The IRS agreed to defer tax on that income — and on all subsequent investment gains — until the money was distributed. At distribution, the tax bill that was deferred comes due. That deferred income is taxed at ordinary rates, because that is what it is: deferred ordinary income.¹

The long-term capital gains preference exists because capital gains are taxed differently from ordinary income in the U.S. tax code. But for IRA money, there are no "gains" in the capital gains sense. The investments inside the IRA may have grown substantially, but those gains were sheltered inside the tax-deferred wrapper. When the wrapper comes off at distribution, the character of the income is ordinary — determined by the original deferral agreement, not by what the assets did inside the account.

This has been the law since IRAs were created in the Tax Reform Act of 1986 and the original 1974 ERISA framework. No subsequent legislation has changed it. The SECURE Act (2019), SECURE 2.0 (2022), and the OBBBA (2025) all changed distribution timing rules — none changed the character of distributions from ordinary income.

Ordinary income rates vs. long-term capital gains rates in 2026

The tax difference between ordinary income and long-term capital gains is enormous. Here's the direct comparison for 2026:

Ordinary income brackets per IRS Rev. Proc. 2025-32 (2026 inflation adjustments). LTCG thresholds for 2026 per Rev. Proc. 2025-32 and IRS publication. Standard deduction is $16,100 (single) / $32,200 (MFJ) in 2026 — applied to gross income to reach taxable income.

The practical impact: a married couple with $200,000 in taxable income could sell $100,000 of appreciated stock from a taxable brokerage account and pay 15% federal capital gains tax ($15,000). If they instead take the same $100,000 as an inherited IRA distribution, they pay 22% ordinary income tax ($22,000) — and possibly more depending on bracket stacking. That's a $7,000 difference on a single $100,000 withdrawal, before state taxes.

Selling investments inside the inherited IRA: still ordinary income at distribution

A related misunderstanding: some beneficiaries believe that if they sell a long-held stock inside the inherited IRA, the gain is taxed at capital gains rates because the position was held for years. It isn't.

Within an IRA, all transactions are tax-free. You can buy and sell stocks, bonds, mutual funds, and ETFs inside the inherited IRA without generating any taxable event. No capital gains, no short-term gains, no 1099-B from trades inside the account. The tax deferral continues until money leaves the account.

When you take a distribution — whether the account holds the same stock it held for 30 years or cash from a trade made yesterday — the distribution is ordinary income. The holding period of individual positions inside the IRA is irrelevant to the tax treatment of the distribution.

The step-up in basis contrast: why taxable accounts are different

Here is where the inherited IRA sits at a major disadvantage relative to inherited taxable accounts:

When someone dies holding stocks or real estate in a taxable brokerage account, IRC § 1014 provides a "step-up" in cost basis to the fair market value at the date of death.² If your parent paid $10 per share for stock that is worth $100 per share at death, your new cost basis is $100. If you immediately sell at $100, you owe zero capital gains tax. Even if you hold and sell years later, only appreciation above $100 per share is taxed — and at the preferred long-term capital gains rate if held more than one year.

IRAs receive no step-up in basis. They never have, because the basis concept doesn't apply the same way — the IRA contained pre-tax dollars that were never taxed at any point. The deferred ordinary income is what gets taxed at distribution, regardless of how long the account existed or how much it grew.

For a mixed estate — where you inherit both a brokerage account and an IRA — this difference has a direct strategic implication. You generally want to spend the taxable assets first (where tax-free or low-rate treatment exists) and preserve the IRA as long as possible (where taxes are higher). But the SECURE Act 10-year depletion rule puts a hard time limit on that strategy. A fee-only advisor can model the optimal sequencing for your specific asset mix.

Worked example: the capital gains illusion on a $600,000 inherited IRA

Your father opened an IRA in 1990 and contributed $120,000 over his working years. By 2025, it had grown to $600,000 — a $480,000 gain. You inherit it.

What many people assume: the $480,000 in gains will be taxed at long-term capital gains rates — maybe 15% — because the account held appreciated assets for decades.

What actually happens: every dollar you distribute is ordinary income. If you are married filing jointly with $80,000 in other income and you take $60,000/year over 10 years:

• Gross income each year: $80,000 + $60,000 = $140,000
• Standard deduction: −$32,200
• Taxable income: $107,800
• All $60,000 of the IRA distribution lands in the 22% bracket for MFJ ($100,801 – $211,400)
• Marginal tax on the distribution: approximately $13,200 per year
• Over 10 years: roughly $132,000 in federal tax on $600,000 of distributions (before growth and state taxes)

Had the same $480,000 gain been in a taxable brokerage account: stepped-up basis to $600,000 at death, zero capital gains tax on the $480,000 of appreciation at the moment of inheritance. Even subsequent growth would be taxed at 0–15% LTCG depending on your income level — dramatically less than 22% ordinary income on every dollar from the IRA.

The inherited IRA is not without value — the tax deferral during accumulation was real. But the distribution phase has a higher tax cost than many beneficiaries expect, and that gap makes planning the withdrawal schedule worth substantial attention.

Inside the IRA: asset location still matters

Even though all distributions are eventually taxed as ordinary income, what you hold inside the inherited IRA can affect the size of your distributions and the timing flexibility you have.

Two principles apply during the 10-year window:

1. Tax-inefficient assets belong in the IRA

If you have a choice about which assets to hold inside the inherited IRA vs. in a taxable account, favor putting tax-inefficient assets (bonds, REITs, actively managed funds with high turnover) inside the inherited IRA where their yield or distributions don't generate current tax. Hold tax-efficient assets (index funds, growth stocks) in taxable accounts where they benefit from lower capital gains rates and the step-up in basis at your own death.

This is called "asset location" — and for a beneficiary simultaneously managing a taxable portfolio and an inherited IRA, it's a meaningful lever. The inherited IRA generates ordinary income regardless, but you can minimize the ordinary income generated outside the IRA by routing the high-yield assets inside.

2. Avoid selling appreciated assets inside the IRA to fund distributions unless necessary

Within the IRA, it makes no tax difference whether you sell an appreciated position or a bond to fund a distribution — the distribution itself is ordinary income either way. But if you have a choice between selling an appreciated stock inside the IRA vs. an appreciated stock in a taxable account, selling the taxable account stock at capital gains rates may be preferable. This frees up cash from the low-tax pool and delays the higher-rate IRA distribution.

In practice, this coordination requires looking at the full portfolio — not just the inherited IRA in isolation. See the full guide: Inherited IRA Investment Strategy: the bucket approach for the 10-year window.

Two exceptions: Roth IRAs and after-tax basis

Inherited Roth IRA: tax-free, not just capital-gains-rate

If you inherit a Roth IRA, qualified distributions are completely income-tax-free under IRC § 408A — not merely taxed at capital gains rates, but actually zero federal tax. A "qualified distribution" from an inherited Roth IRA generally requires that the original owner's Roth IRA had been open for at least 5 years (the 5-year rule clock started on the original owner's first Roth contribution, not the year of inheritance).³

The SECURE Act 10-year depletion rule still applies to inherited Roth IRAs for non-spouse beneficiaries. But within that 10-year window, distributions are tax-free if the 5-year rule is satisfied — making deferred withdrawals from an inherited Roth IRA the preferred strategy: let the account grow tax-free, then empty it in year 10. Full guide: Inherited Roth IRA Rules.

After-tax basis: partial recovery via Form 8606

If your decedent made non-deductible contributions to their traditional IRA, those after-tax dollars carry a "basis" that transfers to you at death. Basis recovery is calculated pro-rata across all inherited IRA distributions using Form 8606 — a separate 8606 from the one tracking your own IRA basis.⁴

The basis portion of each distribution is tax-free (you're recovering money that was already taxed). The remainder is ordinary income. In practice, most inheritors have no idea whether the decedent had after-tax contributions — the only way to know is to find old Form 8606 filings or the decedent's final return. If the decedent never filed Form 8606 for non-deductible contributions, you'll need to either reconstruct the history or, if records are lost, assume zero basis and pay tax on every dollar. Full guide: Inherited IRA After-Tax Basis and Form 8606.

Net Investment Income Tax (NIIT): an additional layer, but not on the distribution itself

The 3.8% Net Investment Income Tax does not apply to inherited IRA distributions directly — IRA distributions are explicitly excluded from "net investment income" (NII) under Treas. Reg. § 1.1411-8(b). However, inherited IRA distributions inflate your MAGI, which can push your other investment income (dividends, capital gains, rental income) above the $200,000 single / $250,000 MFJ NIIT threshold — indirectly costing you 3.8% on that other income. See the full explanation: Inherited IRA and the 3.8% NIIT.

How the ordinary income character shapes 10-year planning

The fact that distributions are ordinary income — and that rates climb steeply above certain thresholds — drives most inherited IRA planning strategy:

Spread across the 10 years

Ordinary income rates are progressive: higher income means higher rates on the marginal dollars. Spreading the inherited IRA across 10 years keeps each year's incremental ordinary income in lower brackets — the core logic of the "no year-10 lump sum" rule. See the full strategy analysis: Inherited IRA 10-Year Distribution Strategy: equal, front-loaded, back-loaded, or lump sum?

Roth conversions from your own IRA, not the inherited IRA

You cannot convert an inherited traditional IRA to a Roth IRA (IRC § 408(d)(3)(C) prohibits non-spouse rollovers). But you can convert your own traditional IRA to a Roth during the same 10-year window — using the inherited IRA distributions to fund living expenses rather than your own IRA withdrawals. This reduces future ordinary income from your own IRA while you're being forced to distribute the inherited account anyway. See the calculator: Roth Conversion Coordinator.

QCDs for beneficiaries over age 70½

If you are 70½ or older and you inherited this IRA, you can make Qualified Charitable Distributions of up to $111,000 in 2026 directly from the inherited IRA to a qualifying charity. QCDs are excluded from gross income entirely — better than an ordinary charitable deduction, because the exclusion reduces AGI directly, not just taxable income. This is one of the few ways to extract inherited IRA dollars at a 0% federal rate. Full guide: QCD from Inherited IRA.

IRMAA and Social Security calibration

For beneficiaries near Medicare age or already collecting Social Security, the ordinary income character of distributions — and the steep effective marginal rates created by IRMAA surcharges and Social Security benefit taxation — makes careful annual calibration essential. Taking one dollar too many can cost $924+ in additional Medicare premiums two years later. See the full analysis: Inherited IRA and Medicare IRMAA and Inherited IRA and Social Security Benefit Taxation.

Summary: what capital gains treatment would be worth

To quantify the ordinary-income disadvantage: if a hypothetical $500,000 inherited IRA were instead treated like a taxable account with a step-up in basis and capital gains rates, the tax savings could be substantial.

• At 22% ordinary income vs. 15% LTCG, each $50,000 annual distribution costs approximately $3,500 more in federal tax — $35,000 over 10 years on a $500,000 account.
• At 32% ordinary income vs. 15% LTCG, the difference is $8,500 per year — $85,000 over 10 years.
• This is the "cost" of the tax deferral — the IRS collected the deferred ordinary income rate rather than allowing capital gains treatment at distribution. The original owner benefited from decades of pre-tax compounding; the cost is taxed-as-ordinary-income at the end.

That gap is precisely why planning the withdrawal schedule matters — it cannot eliminate ordinary income treatment, but it can ensure that ordinary income falls in the lowest possible brackets across the 10-year window.

Key takeaways

• Inherited traditional IRA distributions are ordinary income, taxed at 10–37%, not capital gains rates (0–20%).
• It doesn't matter how long the IRA existed, what assets were inside, or how much they appreciated — the character is ordinary income at distribution.
• Selling positions inside the inherited IRA generates no current tax; the tax only arises at distribution.
• Inherited Roth IRAs are the exception — qualified distributions are tax-free.
• After-tax basis in the decedent's account can reduce the taxable portion via Form 8606.
• The ordinary income character makes spreading distributions across 10 years, calibrating to IRMAA tiers, and coordinating with Social Security the central planning levers.