Double, Double, Toil and Trouble

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

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 Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 25 years of experience in the industry. Read more from this author