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Estate Taxation of IRA


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#1 Greg_de2000

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Posted 28 October 2008 - 09:53 AM

Hello,


How is an IRA taxed for estate purposes? If it is taxable within the Estate, how is the Inherited IRA taxed when funds are withdrawn?


 


 



#2 pg1067

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Posted 28 October 2008 - 10:25 AM

Your question is ambiguous.  I assume that the deceased owned the IRA, but you don't indicate how, when, or to whom the money in the IRA was distributed, what happened after that, or whether this is a regular IRA or a Roth IRA.  For example, if a regular IRA is distributed to the designated pay-on-death beneficiary, who then puts the money in an IRA of his/her own, I do not believe there would be any tax obligation.  On the other hand, if there is no pay-on-death beneficiary and the money is distributed to the estate and then further distributed to the beneficiaries of the estate, I believe the executor has the option of having the estate pay the taxes or passing the obligation on to the beneficiaries (whom may have lower marginal tax rates than the estate).  If you are the executor of the estate in question and/or one of the beneficiaries and do not understand the tax ramifications of the transaction, you need to consult with a tax professional for advice.

#3 Tax_Counsel

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Posted 28 October 2008 - 11:47 AM

The IRA is taxed upon the distribution of the IRA. The issue becomes when the distribution must be made. There are different rules for that depending upon who the pay-on-death (POD) beneficiary of the IRA is. This is different than who the beneficiaries of the estate are. The POD beneficiary is the person named as a beneficiary of the IRA in the IRA contract.

If the beneficiary is the spouse of the decedent, he or she can elect to treat the IRA as his/her own IRA rather than as an inherited IRA. If the surviving spouse does that, then all the rules for distributions for the surviving spouse would apply (including early withdrawal penalty if the spouse takes withdrawals before age 59 and a half). It also means that he/she can roll the IRA over into a new IRA and avoid immediate taxation of the money. This allows him/her to change the investments in the IRA. He or she should see a tax lawyer or other tax professional familiar with the IRA rules to determine if that election should be made and, if so, get help in making the election properly.

If the IRA POD beneficiary is some other individual (i.e not the spouse) then the special rules for inherited IRAs applies. While you can change the investments for the inherited IRA (which is new, you before last year you could not do that), you cannot move it into an IRA of your own. It must remain as an "inherited IRA." Thus, among other things, you cannot add it to other existing IRAs that you have and the distribution rules will be different. The rules for when the distribution must be made and the amount of the minimum distribution here relate to when the decedent would have had to take distributions from it. The rules for this are too complex to go into in a message board forum like this one. I suggest you read IRS Publication 590, which explains them in detail with some examples.

If the estate is the POD beneficiary or the owner of the IRA by default because there was no POD beneficiary named, the distributions may have to be made entirely within 5 years of the date of death. Again, Publication 590 discusses this. Thus, if the estate owns the IRA, the executor will need to see if this rule applies or whether the a longer distribution period may be used. There may be a choice of distributions and the executor should consult a tax attorney for advice on when the distributions should be taken by the estate. Once distributions are taken by the estate, if the estate makes distributions of property (and it doesn't necessarily have to be the funds from the IRA that are distributed) to the beneficiaries, the taxable income from the distribution will pass up to them to the extent of the distribution and thus they pay the tax on that passed up income. This can be advantageous because the beneficiaries are likely to be in a lower marginal tax bracket than the estate. Here, a tax attorney should be consulted on the timing of estate distributions if the probate attorney is not familiar with the income taxation of estates.

In general, there is no penalty for distribution of an inherited IRA prior to the beneficiary reaching age 59 and a half.

You can get forms and  publications at most IRS offices, have them mailed to you by calling the IRS toll free at 800-829-3676 (800-TAX-FORM), or download them from the IRS at:
http://www.irs.gov/f...pubs/index.html


#4 Tax_Counsel

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Posted 28 October 2008 - 12:16 PM

I’ve said it on these boards before, and I’ll repeat it again now. Folks who are not tax professionals really shouldn’t try addressing technical tax issues on these boards.

“For example, if a regular IRA is distributed to the designated pay-on-death beneficiary, who then puts the money in an IRA of his/her own, I do not believe there would be any tax obligation.”

Your belief is only correct in that circumstance if the POD beneficiary is the surviving spouse of the decedent and she elected to treat the IRA as her own. In all other cases, it’s not correct. If the IRA POD beneficiary is instead someone other than the surviving spouse or the surviving spouse does not make the election, then it is an inherited IRA. With an inherited IRA, you can change the IRA assets (e.g. move it from a fund invested in stocks to a fund invested in bonds) but you cannot put it into an IRA of your own. Furthermore, in order to change investments for an inherited IRA tax free, a direct transfer from one IRA to another is required. If a distribution is made to the beneficiary, that will trigger the income inclusion to the beneficiary even if the funds are subsequently put into another IRA. This is unlike the rule for an IRA of your own. With your own IRA, you can take a distribution from the IRA and reinvest it in another one within 60 days and that will qualify as a tax-free roll over. Not so with inherited IRAs.

“On the other hand, if there is no pay-on-death beneficiary and the money is distributed to the estate and then further distributed to the beneficiaries of the estate, I believe the executor has the option of having the estate pay the taxes or passing the obligation on to the beneficiaries (whom may have lower marginal tax rates than the estate).”

That’s not correct. Once the estate distributes property to the beneficiaries in the year of the IRA distribution, the income from the IRA distribution automatically will pass to the beneficiaries to the extent of the property distributed. In short, if all the IRA distribution got passed up to the estate beneficiaries, then all the income from the IRA distribution will pass up to them as well. (For simplicity, I am assuming no other income or deductions for the estate in that year. It’s more complex to describe the effect when the estate has other tax items during the year.) The executor does not get to elect in that case for the beneficiaries to take the income inclusion. Similarly, if the estate makes no distributions, none of the income would pass up to the beneficiaries and the estate would pay the tax on the IRA distribution. The choice the executor has is whether to make distributions to the beneficiaries.  In making that choice, the executor should take into account the tax consequences. Once that choice is made, however, the tax consequences are automatic.



#5 Greg_de2000

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Posted 28 October 2008 - 02:15 PM

TAX COUNSEL _ Thanks!    Additional facts: The decedant's spouse pre-deceased and the IRA beneficiares were three children. So, from your response I assume the following:


1. The IRA is not part of the taxable estate.


2. The beneficiaries have an "Inherited IRA" that is a permanently total IRA that has the specail rules for how much is withdrawn annually.


Thanks again!



#6 Tax_Counsel

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Posted 28 October 2008 - 06:51 PM

If the IRA named the 3 kids as pay-on-death beneficiaries, then the IRA would not be part of the probate estate. Thus, the executor would not be responsible for handling the IRA. However, it would be part of the gross estate for federal estate tax purposes, if federal estate tax is a possibility. For decedent's dying in 2007 and 2008, in general if the value of the estate plus any taxable gifts made prior to death exceed $2 million, then federal estate tax made be owed. It might also be included in the taxable estate for state inheritance or state estate tax, if his state has either of those two kinds of taxes. Those taxes may apply to estates much smaller than the federal estate tax does.

The discussion I gave before concerned the income tax treatment of the IRA. Since the beneficiaries are his 3 kids, it is an inherited IRA and the rules regarding the timing and required minimum distributions for inherited IRAs would apply.


#7 Greg_de2000

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Posted 28 October 2008 - 08:28 PM

TAX_COUNSEL


Thank you for the clarification! It brings up one more question. Since the IRA is includable in the gross estate, is there a step-up in basis on the inherited IRAs? When the annual distribution is made, what is the portion that is now personal taxable income to the beneficiary of the inherited IRA?


Thanks!


 



#8 harrylime

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Posted 28 October 2008 - 11:51 PM

The IRA does not receive a step-up in basis.


If the contributions to the IRA were pre-tax, then the distributions are ordinary income.



#9 Tax_Counsel

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Posted 29 October 2008 - 02:40 AM

Although assets that are received by inheritance and included in the gross estate do get a step up in basis, distributions received from an inherited pension, 401(k) or IRA are not affected by the step-up. These kinds of payments are known as "income in respect of the decedent" (IRD), and the basic idea of IRD income is that it is taxed to the beneficiary much in the same manner as it would have been had the decedent taken the distribution from the plan.


#10 Greg_de2000

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Posted 29 October 2008 - 06:32 AM

GENERAL COMMENT:


 


Thanks to both of you for your guidance. This is shocking. So, if the estate is $3,000,000, {assuming no prior gifts}, and includes $1,000,000 in IRA assets, the total possible tax could be: 55% in Estate Tax and assume an individual rate of 30%, that would be a total of 85% in taxes! Great Country!


It would be better to cash in IRAs {if you have the overall ability} pay the tax of 30% to 35%, and that would leave $300,000 less in the estate, for a savings at 55% on the $300,000 tax that was paid.


 



#11 Tax_Counsel

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Posted 30 October 2008 - 05:08 PM

First, note that currently the top rate for the federal estate tax is 45%, not 55%. Second, in your example, while it's true for a decedent dying this year with an estate of $3 million, $1 million of it ends up taxed at 45% and the IRA is also taxed as ordinary income when it's distributed, it's not as bad you make it out to be. First, remember that $2 million of the estate passes out tax free from the estate. Thus, the overall effective tax rate for the federal estate tax in this example is $450,000/$3 million = 15%.  That is not a terribly onerous estate tax. Thus, the credit that shelters $2 million of the value of the estate is a tremendous benefit. Furthermore, the IRA is not taxed until distributed, giving the beneficiary the benefit of deferral of the tax until he gets the distribution. That deferral, in today's dollars, can greatly reduce the effective income tax cost of the IRA as well.

Taking all the distribution before you die might save some tax in the long run, but it could be worse, too. You'd have to run the numbers under a variety of possible outcomes to see if it's a good thing to. That's because you don't know what the future holds and different outcomes in the future will have different tax effects. For example, for decedents dying in 2009, the estate tax credit is worth $3.5 million, which in your example would eliminate all the estate tax. In that situation, taking out the distribution early could well be a bad move, since you lose the benefit of deferral and your tax rate may be higher than the rate of your beneficiary. Congress is likely to change the estate tax in some form before 2011 when the estate tax credit will once again be $1 million.





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