There are very few tax issues more complicated than the intersection of estate taxes, income taxes, and IRAs. Very few couples exceed the $24million exemption amount to begin with, and even fewer get this part of their planning correct. If not navigated well, this confluence of factors can conspire to cause 80% of an IRA or 401k to be lost to taxes. There are solutions, including going back three years to amend returns if this causes an aha moment.
The core of the issue is that deferred taxes in a retirement account can contribute to estate taxes while income taxes are still owed on the same balance. The IRS does have rules intended to alleviate this travesty. However, knowledge of these rules is incumbent upon the recipients of inherited IRAs because their parents’ tax planning requires next-generation follow through to escape the two layers of tax grab that might occur. Perfect execution of the plan is unlikely when the estate attorney prepares the estate tax return, and the kids might be on their second or third CPA when they distribute the IRA ten years after the second parent’s death. (The first death is moot since spouses have no tax responsibility except for maintaining RMDs.) It is the non-spousal inheritors who must be paying attention.
When an estate breaches that $24.12 million joint balance and contains an IRA, estate taxes are due on the whole amount above that, including the IRA. However, a credit is given so that deferred income taxes will not apply upon withdrawing those IRA balances in the future under IRS code 691(c). The IRD rules (Income in Respect of a Decedent) give a tax deduction for the estate taxes paid when calculating the income taxes due on IRA distributions. This deduction prevents double taxation. But IRAs inherited by non-spouses now have a required 10-year liquidation phase. Who of the next generation will remember that they are due a tax deduction upon distribution a decade later? And what CPA is monitoring the unused IRD deductions pending from the prior generation who was not their client?
This is why it is probably best for owners of large IRAs with a significant net worth to either fully distribute their IRAs late in life, name a charity or foundation as the beneficiary, or convert them to a Roth. These paths would rinse the accounts of income tax liability and make it impossible for the kids to get double-dipped later.
Tax deferral on retirement plans offers little value in our final years anyway. Of course, everyone’s situation is different, but a several-year plan of forced depletion or Roth conversion past age 80-85 would make sense for most.
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