The Right Way to Lower Your Tax Bill on an Inherited IRA

Q: My dad has a traditional IRA with non-deductible, after-tax contributions. He has to figure out the taxable and non-taxable portion of the distribution every time he withdraws money. I will inherit the IRA when he passes away. As the beneficiary, do I need to do the same thing when I take distributions? – Max Liu, West Hills, Calif.

A: Yes, you will have to do the same thing your father does or you’ll end up paying more taxes than necessary when you take the money out, says Jeffrey Levine, a CPA and IRA technical consultant at IRAHelp.com.

Here’s why: You can’t deduct your IRA contributions on your taxes if you already participate in an employer-sponsored retirement plan such as a 401(k) and earn more than $71,000 as an individual or $118,000 as a married couple. But you can still contribute up to $5,500 a year in 2015 ($6,500 if you're 50 or older) to a non-deductible IRA.

When you fund a non-deductible IRA, as your dad has done, you have already paid income taxes on that money. Unfortunately, the onus is on you, the account holder, to show the IRS that the taxes have been paid. You do that by filing IRS form 8606 each year you make after-tax IRA contributions. (The institution where you keep your account won't keep track.)

If you don’t, the IRS has no record that you ever paid taxes on money in your IRA. But even if you do the paperwork properly upfront, you must file form 8606 again when you take withdrawals to prove that you already ponied up to Uncle Sam.

Though many rules are different when you inherit an IRA (more on that later) vs. funding one yourself, in this case the process is very similar for IRA beneficiaries, says Levine.

When you inherit an IRA that holds after-tax contributions, you must also file Form 8606 to claim the non-taxable part of the distribution, even if your dad already did. If you don’t, you’ll essentially be paying taxes on money that's already been taxed. It's even more complicated if you also have your own IRA with after-tax funds. You have to file two 8606 forms, one for your own IRA and one for your inherited IRA, says Levine. But it's worth the effort.

“Taxes are bad enough to start," says Levine. "There’s no reason anyone should pay more than they should just because of poor record keeping.”

You might wonder why anyone would make contributions to an IRA when you can’t get a tax break and all that paperwork is involved. After all, even when people qualify for tax breaks, not a lot of money is flowing into IRAs on a regular basis. But making non-deductible contributions still has benefits. Your investment grows without the drag of taxes, and you don’t pay tax on earnings until you withdraw them.

Keep in mind that when you inherit an IRA, a lot is different from when you own an IRA that you opened yourself. You can’t contribute new money to an inherited IRA and you can’t roll it into another IRA. Unlike regular IRA holders, who don’t have to start taking distributions until after age 70½, you generally have to begin taking money from the account the year after you inherit it.

It’s not wise to withdraw the money all at once though, says Levine. “Many people take the money and run. But that money is immediately taxable, and the income could phase you out of other tax breaks.”

You can reduce the tax hit by taking money out over time. The IRS requires you to withdraw a minimum amount based on your age and the year you inherit the money. You can use a calculator like this one to figure out the annual minimum. If you don’t take at least that much, you’ll be hit with a penalty. Plus, the longer you keep money inside the IRA, the more you benefit from the tax-deferred growth, adds Levine.

This can be complicated stuff, so you may want to consult with a tax expert or financial adviser who has experience in this area.

It’s terrific that your father has been diligent about his record keeping and taxes. To make the most of his legacy, you’ll have to be too.