Double, Double, Toil And Trouble

Avoiding Double Tax on an Inherited IRA double the fun

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?

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