Retirement > 401(k)s & IRAs
How the IRS helps IRAs
August 23, 2000: 10:26 a.m. ET

A little-known deduction can save IRA beneficiaries thousands of dollars
By Ed Slott
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NEW YORK (CNNfn) - Have you inherited an IRA and are still in a state of shock over the combined estate and income tax bite of over 70 percent?

If your loved one left you a chunk of money that is now a part of your nest egg, the IRS will help you protect it on your road to a comfortable retirement.

Believe it or not, the IRS allows a little known income tax deduction that is graphicavailable to many IRA beneficiaries. However, most IRA beneficiaries are not aware of it and miss out on thousands of dollars in tax deductions every year.

The deduction is commonly available to a non-spouse IRA beneficiary, such as a child. The purpose of the tax deduction is to offset the cost of outright double taxation (estate and income tax) on an inherited IRA.

The government lets you deduct any Federal estate tax paid on an IRA you inherit whenever the IRA is subject to both taxes. But the deduction is only for Federal estate tax, so on the state level, double taxation still exists.

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If you inherit an IRA from your father, for example, the first thing you want to find out is whether or not Federal estate tax was paid on the IRA in your father's estate. If the answer is no, then you are not eligible for this tax deduction, since the IRA was not subject to both estate and income tax.

If there was Federal estate tax paid in your father's estate, then you have yourself an income tax deduction.

You, as the IRA beneficiary, will claim the deduction on your personal tax return (Form 1040) as a miscellaneous itemized deduction on Schedule A. Although most deductions in the miscellaneous itemized deduction category are reduced by 2 percent of your Adjusted Gross Income (AGI), this one is not.

This deduction commonly known as the "IRD Deduction" or the "Estate Tax Deduction" is also not subject to the Alternative Minimum Tax. The IRD stands for Income in Respect of a Decedent. This is a tax term. IRD items are those items, like an IRA, that when you inherit them and withdraw them, become subject to income tax.

How does it work? Let's take a very simple example and you'll be surprised at how big the tax deduction can be.

Example: You inherit an $800,000 IRA from you father. Assume that from the Federal estate tax return, the Federal estate tax bracket was 40 percent. This means that $320,000 ($800,000 x 40 percent = $320,000) of Federal estate tax was paid on the IRA in your father's estate. You are entitled to a tax deduction of $320,000! The deduction is claimed as you withdraw from the inherited IRA.

Hopefully, you would not withdraw the entire $800,000 in one year, but just for this example, let's assume you withdrew the entire $800,000 this year. This would push you into the top income tax bracket of 39.6 percent plus any state tax. Assuming a combined Federal and state income tax rate of 45 percent, the total income tax due on the $800,000 IRA distribution would be $360,000 ($800,000 x 45 percent = $360,000). That's why you would not want to withdraw the IRA all in one tax year. But let's continue with the example.

If you began with $800,000, lost $320,000 in Federal estate tax and now lost an additional $360,000 in income tax, that leaves you with only $120,000, or 15 percent of the original IRA. So far, 85 percent of it has been consumed in taxes! Ouch.

This is when the IRS starts to feel your pain, and will help you lessen the overall tax impact by allowing an income tax deduction for all of the Federal estate tax paid. That means you are entitled to deduct the $320,000 of Federal estate tax that was already paid. This is the IRD deduction. That's a huge tax deduction. Imagine if you missed it. How would you feel losing a legitimate tax deduction of that size?

At the 45 percent combined income tax bracket we assumed above, your IRD deduction would be worth $144,000 in cash to you ($320,000 x 45 percent = $144,000). Your income tax bill of $360,000 would be reduced to $216,000 due to the actual tax savings of $144,000. In effect, you are not paying tax on $800,000, but only on $480,000, which is the $800,000 less the IRD deduction of $320,000. The deduction will generally be reduced slightly by 3 percent of your AGI, but that reduction cannot be helped and still nets you a hefty tax deduction.

Read Ed Slott's recent columns on the three most important decisions you'll make with your IRA: Choosing a beneficiary; picking a life expectancy and picking a distribution method.

As I said above, no beneficiary should withdraw the entire inherited account in one year. I only set up that example to illustrate the big tax deduction available to you, as an IRA beneficiary.

You can only take the deduction proportionately to how much you withdraw. In our example, the entire $320,000 of Federal estate tax paid was deducted because the entire IRA was withdrawn by the beneficiary.

If only 10 percent of the IRA was withdrawn, then only 10 percent of the IRD deduction can be taken in that year, but the remainder of the IRD deduction is never lost. The deduction is taken each year as you withdraw from your inherited IRA until the full IRD deduction is used up. This means then that if you intend to withdraw over say 20 or 30 years, you'll receive the IRD deduction each year until the entire $320,000 deduction has been taken.

If you are an IRA beneficiary, see what this deduction can be worth to you. Don't miss out! Or it could cost you a bundle on your road to riches. Back to top


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