Can I avoid Fed/State income tax on an inherited IRA withdrawal made to pay estate tax that wasn't deducted from the inheritance at the time of estate settlement in 2012?

[philrom72]

The withdrawal amount is included in the 2017 1099-R. The "rationale" for income tax avoidance is that the amount withdrawn from the inherited IRA would not have been part of the inheritance (and therefore not subject to income tax) had the estate tax had been properly deducted at the time of settlement.

[dmertz]

Your rationale is somewhat flawed.  Estate taxes paid do not reduce the size of the taxable estate, nor do they reduce the taxable income to the estate.  What the law *does* permit you to do is take an Estate Tax Deduction on your tax return for Income in Respect of a Decedent (IRD) up to the amount of your share of the estate taxes paid by the estate.

See Estate Tax Deduction in IRS Pub 559:  https://www.irs.gov/publications/p559#en_US_2017_publink100099618

To enter this into TurboTax, go to Deductions & Credits -> Other Deductible Expenses, answer No to Less Common Expenses, answer Yes to Any Other Deductions?,  then enter the Estate Tax Deduction, computed by you as indicated in Pub 559.

[philrom72]

Thank you dmertz.  Unfortunately, I don't have enough deductions to itemize even with the estate deduction. It doesn't seem fair, but I might be stuck.....the additional estate tax amount should have been paid by the admin back in 2012 before the inheritance was given out.  Had that happened, I would have received the inheritance minus that amount.  Now what I have, is an inheritance amount reduced by the same estate tax amount via withdrawal from the inheritance IRA, PLUS state and income tax liability that I would not have incurred had the estate tax been paid correctly back in 2012 before the inheritance was paid out to me.

[dmertz]

If you were the beneficiary of the estate, either the estate would have paid the state income tax and you would have received less distributable net income from the estate or the tax liability for income from the IRA would have been passed through to you for taxation on your own state tax return.  The net result would be essentially the same as what you have now.  The income taxes you are paying now are are simply those that you would have paid in 2012 had the distribution from the IRA occurred in 2012.  There would have been no change in estate taxes.  The only difference that you might possibly see is if the decedent lived in a state where you were subject to inheritance tax, in which case inheritance taxes might have been lower.

[philrom72]

Thank you again.  So, my flaw was not recognizing the income tax liability that would have been incurred anyway even if the estate tax was paid directly out of the estate before distribution to the heirs.  I think I've got it. Much appreciated.