Beneficiaries of an inherited individual retirement account (IRA) are typically not privy to the income tax filings of the decedent. The result is that some beneficiaries end up paying more tax on their inherited IRA distribution than was required.
How does this happen? One answer: basis.
Unlike other assets, the basis of an IRA in the hands of the beneficiary is that of the decedent. Retirement accounts, including IRAs, do not get reset to fair market value on the date of death. Thus, knowing whether the decedent had basis in their IRA is critical for the beneficiary to know.
The former IRA owner may have made contributions to the IRA that were designated as nondeductible or rolled over into their IRA qualified retirement plans that contained after-tax contributions. Without knowing this information, the beneficiary would be needlessly paying tax on 100% of the IRA distribution, when in fact a portion of the distribution is tax-free.
For example, a taxpayer decedent left a $1 million IRA to his sole heir. That heir decided to take the IRA distribution in one lump sum. Assuming the heir is in a 34% combined federal and state tax bracket, the heir pays $340,000 in income tax on the distribution. However, unbeknownst to the heir, the decedent had made $150,000 of nondeductible IRA contributions over the years. Had the heir known this, the heir would have only paid $289,000 of income tax on the inheritance, saving $51,000.
So how does one begin to investigate whether the decedent had basis in their IRA? The first place to start is with the decedent’s federal tax returns for the last three years. Look for Form 8606 “Nondeductible IRAs,” which is filed to report and keep track of nondeductible contributions. This form will show the decedent’s basis in the IRA, which passes to the beneficiary. Those last three years of tax returns should establish consistency. It is important to examine whether the 8606 was consistently filed, consistently not filed, or filed in one of the years but not the others. The beneficiary can then use this basis to reduce the portion of the IRA distribution that is subject to tax.
Not all taxpayers who have made nondeductible contributions file this form, so if no Form 8606 is found in the three years of returns, do not stop there. The form is only required to be filed when basis exists and there are distributions. Even then, this can be overlooked if the person preparing the tax returns was not familiar with the form. Thus, it’s worth the effort to do some spot checking.
Contact the IRA custodian to obtain Form 5498 for as many years as possible. This form shows, among other items, the amount of IRA contribution made during a particular year. For instances where Form 5498 shows an IRA contribution, check the tax return for the year of the form, as well as the preceding year. If neither tax return is showing an IRA deduction and no Form 8606 was included, then this would be strong indication that IRA basis was not being tracked, and thus, merits further investigation.
For questions regarding this issue, please contact Laurence C. Rubin, CPA, Aronson’s tax controversy lead partner, at 301.222.8212.