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December 2012 Tip of the Month

IRA Tax Traps

Did you know that an inherited IRA can be taxed twice?  First, it can be included in the estate of the original owner where it is subject to estate tax.  Then, when it is distributed to the heirs, it is treated as their taxable income and subject to income tax.  However, with some planning this double tax can be reduced. 

Suppose you inherited an IRA from a relative that held $100,000 in deductible contributions and $20,000 in non-deductible contributions.  Suppose this was worth $190,000 at the time of death and $200,000 when you received it.  If you took the entire $200,000 and withdrew it at once, here’s how you would have to report it.

The $20,000 non-deductible contribution is a tax-free return of capital.  The $10,000 resulting from appreciation from the time of the relative’s death till you received the money is your taxable income just as though you had owned an IRA.  The remaining $170,000 must also be reported in your income, but as “income with respect of a decedent.”  This means that it is eligible to be reduced by estate taxes that were paid on the asset.   Thus, if the relative’s estate was in the 35% bracket, $66,500 ($190,000 x .35) could  be deducted as an itemized deduction.

If you are or will be the beneficiary of a relative’s IRA, we strongly urge you to obtain professional tax advice, since the rules are very complicated.