Is an IRA Subject to Estate Tax?

An Individual Retirement Account is granted tax-favored status by the Internal Revenue Service. The tax benefits make it suitable for growing assets during a person's lifetime. However, an IRA is not favored when transferring assets to someone other than a spouse.

Inheriting an IRA

An IRA is included in the taxable estate upon the death of the IRA owner. As of 2011, an estate exceeding $5 million in total assets is taxed at a 35 percent tax rate for federal transfer taxes. This means a $1 million dollar IRA can lose $350,000 right off the top to estate taxes. However, an IRA with beneficiaries named directly on the IRA account does not go through the probate process . This means an IRA owner may not be liable to liquidate the IRA to pay for estate taxes.

Other Taxes

An IRA is not only subject to federal estate taxes when the IRA owner dies. Distributions taken from the IRA are subject to income taxes. Beneficiaries have several distribution options including a lump-sum distribution, a five-year payout or rolling the IRA into a beneficiary IRA. A lump-sum distribution adds the entire IRA value to the beneficiary's income, possibly increasing the tax bracket for all income in that year. The five-year distribution reduces the tax payments, taking distributions over five years. A beneficiary IRA stretches the IRA throughout the lifetime of the beneficiary, requiring only minimum distributions each year.

Considerations

The best way to plan for estate and income taxes on an inherited IRA is for the IRA owner to take measures prior to dying. If the IRA assets are not needed, periodic distributions can be taken to purchase a life insurance policy. Life insurance benefits are not taxed. Beneficiaries then have a non-taxable asset to pay the taxes on the estate. This preserves the estate value.

Sunset Provision

The sunset provision of the 2010 Tax Act re-instated the estate tax which had been revoked for the 2010 year. The 35 percent federal tax rate is effective for 2011 and 2012, but reverts back to 55 percent as of January 1, 2013. Taxable estates will then start at $1 million rather than the $5 million.

references