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.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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5 Comments

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  • Sandra –

    Regarding your first question, in order to determine if the amount is fully taxable, you’d need to know if 1) the contributions to the account were pre-tax or post-tax; and 2) if there was estate tax attributed to the IRA.

    In the case of the first, if the contributions that your husband’s father made were partly post-tax (non-deductible), then part of every distribution would be non-taxable to the beneficiaries.

    Regarding estate tax – if there was tax paid on the overall estate, then it’s possible that a portion of the estate tax paid could be deducted via the IRD tax deduction. See this link for additional details.

    In answer to your question about the QTP distribution, if you own the account in your name and your daughter is the beneficiary, then I believe the 1099Q would be properly issued in your name.

    Hope this helps –

    jb

  • Another question, a distribution from my daughers qualified tuition program was reported with my social security number on form 1099-Q instead of the college student’s. In completing my 2009 taxes I was told I needed to claim the distribution as income (my income is too high to have college writeoffs). Is this correct, should I have requested that a correction on the form 1099Q be made from the financial institution?

  • My husband received distribution from an IRA from his fathers estate. It was reported to IRS on a 1099R form (where taxable amount not determined). We now have to pay taxes on the full amount, because we also cannot determine the taxable amount. I believe that this should have been paid to the estate for later distribution, but instead it was paid directly to the beneficiaries (3 ways). Is is correct to assume that the total amount is taxable?

  • Fred –

    The same could be said for other taxes paid that are, in fact, deductions, such as Real Estate taxes, state and local income taxes, and the like.

    Best wishes –

    jb

  • Thanks Jim. This squares completely with what our tax attorney told us. But why is the 165,000 a deduction, and not a credit? It seems that these taxes were in fact paid (as estate taxes).

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