Financial Strategy: Inherit An IRA, Write-Off The Tax Bill

Inheriting a traditional IRA can be case of good news, bad news. On the positive side, you gain assets. The negative? Withdrawals will 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 Uncle Ulysses dies in 2007. Let's say his estate consists of his house and a collection of mutual funds. You are the only heir. Altogether, your uncle's estate is worth $2.8 million. In 2007, the estate tax exemption is $2 million. So his estate is $800,000 over the limit. The estate tax rate is 45%. So, basically, your uncle's estate owes $360,000: 45% times $800,000.

If those are the estate tax consequences, what about income tax? Your uncle'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 uncle's lifetime will go untaxed. The same is true for mutual funds your uncle held in a taxable account. No matter how much value they gained after he bought them, you can cash them in after his death and owe no tax on those profits.

That's not the case for funds held in your uncle's IRA. They don't get a basis step-up to market value. Even if they appreciated greatly during your uncle'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 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 types of assets are in an inherited IRA.

Calculating Deductions

To arrive at the right deduction, you or your tax pro must calculate how much tax your uncle'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.

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 2008. 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 2009, 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 the beneficiaries. Say you and your brother are equal beneficiaries of the IRA in the above example. The IRD ratio is the same as above: 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. These 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.

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 deductions are reduced for high-income taxpayers. In 2007, taxpayers with income over $156,400 are affected. But this phaseout is scheduled to end. Starting in 2010, even high-income taxpayers will get the full benefit of the IRD deduction.

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

Copyright © 2007 LexisNexis (by Donald Jay Korn  in Investors Business Daily), a division of Reed Elsevier Inc and provided by HNW Inc. All rights reserved