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Many people miss a tax deduction for inherited IRAs

If you inherited a retirement account, and if the estate of the person you inherited it from owed an estate tax, you might be missing a big income tax deduction when you withdraw funds from the account. Many people forget to claim this deduction.

The deduction applies not only to inherited IRAs, but also to inherited 401(k) accounts, certain stock options and unpaid dividends, pretax gains in certain annuities, and some other assets.

The idea is that the IRA (or other asset) already triggered an estate tax for the person who died. So, taxing your withdrawals from the account amounts to taxing the same asset twice. The deduction exists to prevent this double taxation.

To calculate the deduction, you have to figure out how much of the estate tax was due to the fact that the IRA or other asset was part of the estate. Divide that amount by the value of the asset (as listed in the estate tax return), and multiply this result by the amount of your withdrawals in a given year. That’s your deduction for that year.

If you haven’t claimed this deduction on past withdrawals, you might be able to amend your tax returns for the past three years, and get a refund. And of course, you can claim it for any withdrawals going forward.

The deduction has to be claimed on your income tax return as a “miscellaneous itemized deduction.” However, unlike most other miscellaneous itemized deductions, you can claim it in full, and you’re not limited to amounts that exceed 2% of your adjusted gross income. Plus, you can claim it even if you’re subject to the alternative minimum tax.

However, if your adjusted gross income is over a certain threshold (which was $258,250 for single filers in 2015, or $309,900 for couples), the deduction is reduced by 3% of the amount over that threshold.

You should also note that this deduction applies only where the estate of the person who died paid federal estate taxes. If the estate also paid state estate taxes, you don’t get a break for that.

Here’s a thought: If you currently have a traditional IRA and you anticipate that state estate taxes will be owed when you pass away, this is a reason to convert to a Roth IRA. You’ll have to pay income tax immediately on the conversion, but this reduces your taxable estate, and any future appreciation will be tax-free to your heirs, because they won’t have to pay tax on their Roth withdrawals.

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