Avoiding Double Taxation on an Inherited IRA
Did you know that if you don’t pay close attention, you could be paying tax a second time on an inherited IRA – if the original owner’s estate paid estate tax. You won’t find much (if anything) about this at the IRS’ website… not really sure why, but nonetheless, it’s a little-known fact that you can avoid this double tax.
Following are a couple of examples that explain how the IRD deduction works, so that you can avoid the double taxation problem.
First Example
You have become the sole beneficiary of your father’s $400,000 IRA. According to the records for the account, all of the contributions were deductible contributions (more on this later).
When your father passed away, his total estate was worth $1.3 million – the IRA that you will inherit, plus an additional $900,000 in other assets. At the time of his death, the estate tax exemption was $1 million, leaving $300,000 taxable to the estate. Without the IRA, the estate would have been completely non-taxed. At the then-current 55% rate, your father’s estate has paid $165,000 in estate tax.
This creates your Income in Respect of a Decedent (IRD) ratio: the tax attributable to the distribution divided by the size of the IRA. Dividing $165,000 by $400,000 equals 41.25%. This is an important number!
If you took the entire distribution all at once, you would have available the entire IRD deduction of $165,000. However (and – there’s always a however in life, right?) what happens when you take the distribution over many years?
If you began withdrawing $20,000 per year from the account, each year you could deduct $8,250 (41.25%) from the distribution – reducing the taxable income to $11,750. If you continued withdrawing that same $20,000 every year, the same deduction would be available to you – but only until you used up the original $165,000. In this case, it would be 20 years.
If you took different-sized distributions, each distribution would be eligible for the 41.25% deduction, up to the point where the full $165,000 has been used up.
Of course, over time the IRA has the opportunity to grow, so you’ve likely got quite a bit left in the account. Each distribution after the credit has been used up will be completely taxable.
Second Example
For a very quick look at a second example:
Same circumstances as before, except that the rest of the estate was worth $1.2 million, so that the overall estate is valued at $1.6 million when your inherited IRA is included. Total estate tax paid is $330,000 (55% of $600,000). Of that $330,000, the tax attributable to the IRA is $220,000. So your IRD ratio is 55%, the same as the tax – $220,000 divided by $400,000. In this example, every distribution that you take from the account receives a deduction of 55%, until the $220,000 has been used completely.
Photo by Arbron
Recently we talked about the 
Financial professionals sometimes get wrapped up in the overly-complex – retirement projections, Monte Carlo analysis, trust and estate planning, and complicated portfolio design. It often comes to mind that we need to stop and remember what the most important concepts are in successful financial planning, and that can be boiled down to a very simple formula for success.
It is expected that in 2010 there will be more Roth IRA conversions than in any year in the past – maybe all years added together. With all this converting and cavorting going on around IRAs and Roth IRAs, there are bound to be some problems arise.
More Footwear Decends
There is a provision in the Social Security system that many people don’t know much about – the spousal benefit. This benefit is applicable when one spouse has had little or no working history, such as a stay at home mom or dad, and the other spouse has had a working career that has provided enough quarters of earnings to make him or her eligible for a larger Social Security retirement benefit.
As a smart consumer, you have likely heard that it’s a good idea to get your credit report every year from all three services: Experian, Equifax, and TransUnion. You’ve probably also seen the ever-present “Free Credit Report” commercials on the television (unless you TiVo everything and skip past the commercials!) – so you may be wondering: is that the place to go to get the credit reports?
Yet another point that you need to keep in mind as you plan your Roth IRA conversion strategy is the timing of the activities. This is especially true when you have after-tax contributions to your IRAs in addition to the growth on those contributions and the typical deductible contributions. As you’ll see below, in some circumstances it can make a big difference in how much tax you’ll have to pay…
There are three factors that go into determining the Social Security retirement benefit amount – your PIA (Primary Insurance Amount), your FRA (Full Retirement Age), and the age you are when you start receiving benefits. We talked about the PIA 
So, you’ve decided that you’d like to begin taking distributions from your IRA funds – and you’re under age 59½, so you need to structure your distributions as a Series of Substantially Equal Periodic Payments (SOSEPP). (For more background information on the SOSEPP, see 
If you’re planning to take advantage of the First-Time Homebuyer’s tax credit or the more recently announced “long-time homeowner new purchaser” credit – you will not be eligible to eFile your tax return when you claim the credit. To find out more about these credits, see the article at 
