Double, Double, Toil and Trouble

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Avoiding Double Tax 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 about this at the IRS’ website… but nonetheless, it’s a fact that you can (and should!) avoid this double tax.

In the current (2021) estate tax exemption environment, this provision doesn’t apply to very many people. After all, the estate tax exemption is $11,700,000 for 2021 – and although it’s not impossible to breach that amount, it’s a significant number. Presumably if you are in that situation you will have many advisors to help you navigate the potential tax issues, but it never hurts to understand how it all works. Plus, there’s always the possibility, even likelihood, that the estate tax exemption will be reduced in the not-too-distant future.

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 $500,000 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 $12 million – the IRA that you will inherit, plus an additional $11,500,000 in other assets. At the time of his death in 2021, the estate tax exemption was $11.7 million, leaving $300,000 taxable to the estate. Without the IRA, the estate would have been completely non-taxed. At the current 40% rate, your father’s estate has paid $120,000 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 $120,000 by $500,000 equals 24%. This is an important number, make a note of it!

If you took the entire distribution all at once, you would have available the entire IRD deduction of $120,000.  However (and – there’s always a however in life, right?) what happens when you take the distribution over many years, like the 10 possible years of IRA distribution these days?

If you began withdrawing $50,000 per year from the account, each year you could deduct $12,000 (24%) from the distribution – reducing the taxable income to $38,000*. If you continued withdrawing that same $50,000 every year, the same deduction would be available to you – but only until you used up the original $120,000. In this case, it would be 10 years (not counting growth).

If you took different-sized distributions, each distribution would be eligible for the 24% deduction, up to the point where the full $120,000 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 as you reach the end of the 10-year distribution period. Each distribution after the credit has been used up will be completely taxable as ordinary income.

Second Example

For a very quick look at a second example:

Same circumstances as before, except that the rest of the estate was worth $12 million, so that the overall estate is valued at $12.5 million when your inherited IRA is included. Total estate tax paid is $320,000 (40% of $800,000). Of that $320,000, the tax attributable to the IRA is $200,000. So your IRD ratio is 40%, the same as the tax – $200,000 divided by $500,000. In this example, every distribution that you take from the account receives a deduction of 40%, until the $200,000 has been used completely. Any distributions after the credit has been used up will be taxed as ordinary income to you.

It’s important to note that I used the 10-year distribution period for these two examples since that is the current “default” distribution period. The IRD rules are the same not matter what your distribution period is – you just have a different time period over which you may use the IRD deduction. In other words, SECURE did not change how IRD taxation and deduction work.

H/T to reader SS for pointing out my math error in the original. Thanks!