I said other than your spouse because a spouse can elect to treat the inherited IRA as his/her own and rollover the IRA with no current tax consequences.
While a non-spouse beneficiary cannot make such an election, recent changes have given non-spouse IRA beneficiaries more flexibility when it comes to required distributions from an inherited IRA. However, that is a subject for another posting.
First some basic information:
(1) If a person makes non-deductible contributions to a traditional IRA the amount of the accumulated non-deductible contributions are considered to be the “basis” in the IRA.
(2) The non-deductible contributions that make up the basis in an IRA are not taxed when they are distributed. They are treated as a “return of contributions”.
(3) A distribution from an inherited IRA is taxed to the beneficiary in the same manner that it would have been taxed to the deceased. According to IRS Publication 590, “If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA.” So if the deceased had a basis in the IRA than the beneficiary will also have a basis in that IRA.
(4) The non-deductible contributions are not “recovered” first, as is the case with a non-qualified ROTH IRA distribution. Each distribution from the IRA will consist partly of non-taxable basis and partly of taxable deductible contributions, if any, and earnings.
(5) The taxable portion of IRA distributions is calculated on IRS Form 8606 Nondeductible IRAs. You use the balance in all traditional IRA accounts on December 31st of the filing year, the total traditional IRA distributions for the year, and the basis in the IRA to perform the calculation. For purposes of the Form 8606, individual traditional IRA accounts are not treated separately but are “lumped together”.
Let me digress a minute. I had a client who over the years made both deductible and non-deductible contributions to his IRA. He kept the two types of contributions separate. Fully deductible contributions were deposited to one specific IRA account, while non-deductible contributions were deposited to a different account with a different trustee. However, when he retired and began to take annual distributions the combined balance in both individual IRA accounts was used to calculate the taxable portion of the withdrawals. It did not matter from which specific account the withdrawals were made.
(6) You do not file Form 8606 only in a year that a distribution from a traditional IRA is received. Form 8606 is initially filed in the first year that a non-deductible contribution is made to a traditional IRA, and one should be filed with the 1040 for each year thereafter, whether or not additional non-deductible contributions are made, to keep track of the amount of basis.
It is possible that the distribution you received from the inherited IRA may not be fully taxable. If the inherited IRA has a basis then part of the distribution is a non-taxable return of non-deductible contributions.
But how do you know if the IRA you inherited has a basis? You must discover if the Form 1040 for the decedent included a Form 8606. You should be able to find this out from the Executor or Administrator of the estate. You will need to get a copy of the final Form 8606 and you also must determine if there are any other IRA beneficiaries. If the decedent’s IRA is to be evenly divided among his four (4) children then each of the beneficiaries will get 25% of the basis.
If for some reason the Executor or Administrator cannot, or will not, provide you with this information you can try contacting the IRS for information regarding the Form 8606 and the trustee of the IRA to see if there are any other beneficiaries.
If you already know that you will be inheriting all or part of someone’s IRA you can get a head start on things by asking that person what percentage of the IRA you will inherit and if he has a basis in the IRA.
As a non-spouse beneficiary you cannot combine the basis in the inherited IRA with any basis that you may have in your own traditional IRA accounts or with any basis in a traditional IRA inherited from other decedents. So if you receive a distribution from an inherited IRA and from your own IRA in the same year, and each has a basis, you must complete separate Forms 8606 (one for the inherited IRA and one for your IRA) to determine the taxable portions of each distribution.
As with any other tax issue, you should also look into the state tax rules regarding inherited IRAs. For example, traditional IRA contributions are never deductible on the New Jersey state income tax return, so the IRA basis may be greater for NJ tax purposes than it is for federal tax purposes. NJ has a special worksheet that is used to calculate taxable IRA distributions. And New York allows a beneficiary, regardless of age, to claim a pension and annuity income exclusion of up to $20,000 on pension distributions “if the decedent would have been entitled to it, had the decedent continued to live”.
If you received a distribution from an inherited IRA in 2006 and treated it as fully taxable income on your 2006 Form 1040 you may want to go back and check it out in light of the above information. Maybe you will be able to amend your 2006 return and get a check from “Sam” and/or your state! See my posting on “Amending Your Return.”
Whether the distribution from an inherited IRA is fully or partially taxable, you may also be able to claim an itemized deduction for the federal estate tax paid on the inherited IRA balance. But that, too, is a subject for another posting.