Inherit An IRA, Write-Off The Tax Bill

Break Often Ignored

You can get deduction if your wealty aunt's estate already paid the IRS

Inheriting a traditional IRA can be a case of good news, bad news. On the positve side, you gain assets.

The negative? Withdrawals willl be taxable. It doesn't matter whether you empty the account all at once or stretch minimum required distributions over your life expectancy.

You're eligible for a tax break if you inherit an IRA from someone whose estate paid federal estate tax.

If so, you can take tax deductions that many individual taxpayers overlook.Those deductions can cut the tax you'll owe on IRA distributions.

Suppose your hypothetical Aunt Janice died in 2009. Let's say her estate consists of her house and a collection of mutual funds. You are her only heir.

Altogether, your aunt's estate is worth $4.3 million. For 2009, the estate tax exemption is$3.5 million. So, her estate is $800,000 over the limit.

The estate tax rate is 45%. So basically, your aunt's estate owes $360,000: 45% times $800,000.

If those are the estate tax consequences, what about income tax?

Your aunt's house gets a stepped-up basis to its date-of-death value. If it is worth $500,000, you can sell it for $500,000 and owe no income tax. All appreciation during your aunt's lifetime will go untaxed.

The same is true for mutual funds your aunt held in a taxable account. No matter how much value they gained after she bought them, you can still cash them in after her death and owe no tax on those profits.

That's not the case for funds held in your aunt's IRA. They don't get a basis step-up to market value.

Even if they appreciated greatly during your aunt's lifetime, you won't be able to use the bargain tax rate for long-term capital gains.

Instead, withdrawals will be taxed at your ordinary income tax rates. Currently, the IRS collects as much as 35% from all your IRA withdrawals.

But tax reduction is still possible. That's true no matter what type of assets are in an inherited IRA.

For each dollar in income, you can take a deduction proportionate to the federal estate tax attributable to that amount.

Step By Step

To arrive at the right deduction, you or your tax pro must calculate how much tax your aunt's estate would have owed without the IRA.

Suppose the estate tax would have been zero. Thus, the entire $360,000 of estate tax can be attributed to the inherited IRA.

You can take an income tax deduction for that $360,000 when you receive distributions from an inherited IRA.

The next step is to compare the $360,000 in estate tax paid to the size of the inherited IRA. Say that IRA was worth $900,000.

Then you compute what's known as the income-in-respect-of-a-decedent (IRD) ratio. Here, it is 40%: $360,000 in estate tax owed because of a $900,000 IRA.

If $1 million had been in the IRA, the ratio would have been 36%.

Say the ratio is 40%. Then you can take a 40% deduction whenever you take money from the IRA.

Suppose you withdraw $30,000 in 2010. You can take a $12,000 deduction: 40% of $30,000.

This effectively means you owe tax on only $18,000: 60% of your $30,000 withdrawal.

If you withdraw $40,000 in 2010, you would get a $16,000 deduction at 40%, and owe tax on $24,000.

As you take these annual deductions, you must keep track. There is no time limit to taking this deduction. In the above example, after you have taken $360,000 of deductions, you will have equaled the amount of estate tax paid.

From that point on, all of your IRA withdrawals will be fully taxable.

What if you share an inherited IRA? Then the deduction can be shared among beneficiaries.

Say you and your brother are equal beneficiaries of the IRA in the above example. The IRD ration is the same 40%.

So you each can take deductions of 40% of the amounts you withdraw. You and your brother can each take half of the available deductions, so you'd deduct $180,000 apiece.

Those IRD deductions will be reported on each beneficiary's Schedule A. They are considered miscellaneous itemized deductions. But they aren't subject to limits faced by most miscellaneous deductions.

Most deductions in this category must clear a 2% floor. You add them up and deduct anything over 2% of your adjusted gross income.

Lower Threshold

The IRD deduction is not subject to that 2% floor. So you can take a full deduction each year. IRD deductions aren't reduced by the alternative minimum tax.

Under your regular tax calculation, all itemized deducitons are reduced for high-income taxpayers. For 2009, taxpayers with income over $166,800 are affected.

But this phaseout is scheduled to end. Starting this year, 2010, even high-income taxpayers will get the full benefit of the IRD deduction.

For now, make sure you take such deductions, if you inherited an IRA from someone who had a taxable estate. If you didn't, you can file amended returns for up to three previous years to claim refunds.$

Ray Buckner (Chicago, Illinois) provides personal financial planning and wealth management services for professionals in the greater Chicago metropolitan area. His primary focus is serving pre-retirees who are preparing for a successful retirement as well as those who have already retired and want to develop a 100% retirement income personal paycheck. His pre-retiree clients want to focus on replacing 100% of their last year's income and keep their current standard of living through out their retirement adjusted each year for inflation.
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