Estate planning is always a recommended exercise, but if there is a US individual retirement account (sometimes referred to as an “IRA”) involved, careful planning is essential.  Without planning, the tax liability on bequeathing an IRA could exceed 100%.

An individual retirement account is a retirement plan set up by an individual with a financial institution.  Contributions to the IRA are deductible or non-deductible from taxable income subject to certain limitations.  There are other types of IRA’s such as Roth or Education IRA’s, however, the discussion below will be limited to the “traditional” IRA.

The tax with respect to the IRA contributions and earnings is deferred until withdrawals are made.  However, dissimilar to a Canadian RRSP, in the case of an IRA, there is a 10% penalty tax in addition to the income inclusion if withdrawals are made prior to the owner reaching age 59 ½.  There are some exceptions to the 10% penalty tax, but not to full income inclusion.

When the owner of the IRA reaches age 70 ½, they are required to take a “minimum distribution” and include that amount into income.  Failure to take such a distribution would result in a 50% penalty.

Receiving an IRA as a bequest compounds some of these rules mentioned above.  Firstly, unless you are a spouse, receiving an IRA from a decedent and rolling it into your own IRA would cause taxation on the entire amount.  There may be some planning which can be done to at least defer that initial tax liability.

The minimum distribution rules would be based on the IRA recipient’s life expectancy, which can be determined from IRS published tables.  Despite the IRA recipient’s age, a 50% penalty would apply to the first year or any year in which minimum distributions are not made.  If there are joint recipients on a bequest of an IRA, the minimum distribution amount is based on the oldest joint recipient, thus, forcing the younger IRA recipients to withdraw more money from the plan over their lifetime.  You may wish to consider splitting the IRA into separate portions to alleviate this problem. 

If you are a spouse, then there is the option of rolling the IRA into the living spouse’s IRA and using that living spouse’s age in determining the withdrawals.  Alternatively, you may wish to leave the IRA in the deceased spouse’s name and making the distributions when that deceased spouse would have turned 70 ½.

There is also significant planning which could be made if there are charitable inclinations.  Bequests of IRAs to charities could result in significant tax savings as exempt organizations do not pay income tax on receipt of funds from an IRA as an individual would.  However, some risks are involved in minimum distribution planning if one chooses to make a charity a joint beneficiary to an IRA.

The income recognition, with reference to an IRA received from a decedent, is a special type of income called “income in respect of a decedent” or IRD.  IRD is special as the same item of income is subject to both income and estate taxes.  For example, an IRA could be subject to 48% estate tax by a decedent’s estate and 35% income tax. Not considering any minimum distribution or other penalties, the effective rate approaches 80%.  The US provides that when such IRD is taxed, a deduction can be made on the recipient’s tax return for the applicable portion of estate tax paid by the estate on behalf of the IRA.

Query: What if the recipient of the IRA is not a US person (i.e. a citizen or resident of the United States) and resident of Canada?  The first twist is that a non-US person is not permitted the deduction for estate taxes paid on behalf of the estate.

Next, the withdrawals would be subject to US non-resident tax withholding when distributed to the Canadian resident.  In Canada, the Act contemplates that the withdrawals would be subject to Canadian tax to the Canadian beneficiary.  Using Ontario’s marginal tax rates, this would mean that a US IRA subject to 48% estate tax would also be subject to 46% Canadian tax (assuming full credit for the US tax withholding), which exceeds 90%.  Given any planning options, leaving a US IRA to a Canadian, non-US beneficiary would not be an optimal solution.

There is a reasonable basis to believe that Canada should compute the taxation on the withdrawals from the IRA taking into account a deduction for estate taxes paid.  The Act and Canada-US treaty provides that the amount taxable in Canada is based on the taxable income computed as if the recipient were a US person.  As mentioned above, if the recipient were a US person, then they would be entitled to a deduction for estate taxes paid.  Our firm has a case before the Canadian Revenue Agency which advances this above argument for a Canadian, non-US client who was bequeathed a US IRA.  This case was reported in the Globe and Mail on December 24, 2004 on page B7, and we will keep you up to date on its development in this newsletter.