Options Available to the Beneficiary of an inherited IRA
Beneficiaries of an inherited IRA must assess the most optimal treatment based on their relationship to the Decedent.
Inherited IRA from a Spouse
A spouse who inherits an IRA has options available to them that are unavailable to non-spousal beneficiaries. A spouse may treat the inherited IRA as if it is their own by designating themselves as the account holder. A spouse who designates themselves as the account holder will benefit from the traditional attributes of an IRA such as tax-free growth. However, these individuals will also be subject to the withdrawal rules that dictate that an individual must take required minimum distributions (RMDs). The RMDs will be based on the age of the surviving spouse. A spousal beneficiary may also “roll-over” the inherited IRA into a qualified plan such as a qualified employer plan and tax-sheltered annuity plan. Pragmatically, most German domiciled individuals will view these options as being unattractive. Many German domiciled individuals will not want to maintain an IRA in the U.S. Further, many of these individuals will not have a qualified plan for the IRA to be rolled into and there are only a few U.S. financial institutions which offer financial services for nonresidents. In light of these issues, many German domiciled individuals will seek to be treated as a beneficiary and seek a distribution of the assets.
IRA Inherited from a Non-Spouse
An individual who inherits an IRA from a non-spouse will not have the option of treating the IRA as their own or rolling over the IRA. The non-spouse beneficiary will need to receive distributions under the rules applicable to IRA beneficiaries.
Taxation of Payments to the Beneficiary
U.S. Income Tax
If the beneficiary demands a lump sum distribution, the total amount distributed will be subject to taxation in the U.S. as personal income. See IRC § 102, 691. If an IRA is assumed or rolled over, the corpus will grow tax-free and U.S. income tax will only be incurred on the amounts distributed. As the U.S. income tax code is progressive, the tax triggered by a lump sum distribution may subject the beneficiaries to a tax rate that is applicable to the highest tax bracket resulting in significant tax liability. Accordingly, many U.S. attorneys and accountants will advise beneficiaries to assume or roll-over the IRA. Unfortunately, rolling over the IRA may not be feasible for individuals domiciled in Germany.
The application of the Germany-U.S. Income Tax Treaty can have significant ramifications. If a non-U.S. citizen beneficiary`s fiscal domicile within the meaning of Art. 4 of the US-Germany Income Tax Treaty was in Germany at the time of the distribution, the USA does not have the authority to tax the distributions from an IRA or 401(k).However, should the beneficiary be a U.S. citizen, the U.S. also has a right of taxation and double taxation is avoided by offsetting the German tax against the U.S. tax.
U.S. Non-resident Withholding Tax
Even if the U.S. has no taxation right under the Treaty (see above), the U.S. can withhold funds from a distribution to a non-resident alien. The US will seek to withhold funds to ensure all tax liabilities are paid prior to allowing the funds to escape their jurisdiction which result incapturing such liabilities impossible or impractical. Withholding for distributions to non-resident aliens can vary by financial institution and the type of distribution. Generally, U.S. source income received by a non-resident alien is subject to U.S. withholding of 30%. The application of applicable tax treaties should reduce such withholding in many instances, but many risk adverse financial institutions can prove reluctant to acknowledge such treat benefits. When withholding is effectuated, the financial institution will deduct the concerned amount and send it to the US Treasury. The IRS will issue a certificate (Form 1042-S) acknowledging the withheld sum and the burden will then be on the recipient to recover the concerned sum (if possible) by claiming applicable treaty benefits.
As discussed above, financial institutions should not need to withhold tax on payments from an IRA or 401(k) if the benefit of the U.S. Germany Income Tax Treaty is claimed using form W-8BEN. In the case of an IRA (unlike dividend payments), a US tax identification number (ITIN) may be necessary.
Note: Despite accurately completing Form W-8BEN, risk adverse financial institutions can and often do withhold up to 30% of the total amount. In this case, a refund is usually possible - see the article Refund of overpaid US withholding tax.
U.S. Federal Estate Tax
In addition to income tax, U.S. federal estate tax may also be payable. However, due to the high allowances for U.S. citizens ($13.61 million in 2024), estate tax is inapplicable in most cases. If applicable, U.S. income tax (subject to certain conditions) paid can be at least partially credited against the US estate tax.
If the deceased was a non-resident alien, an IRA/401-k is also subject to U.S. federal estate tax as it is considered "U.S. property" (for more information please see the article Taxation of the Estate of Nonresidents under U.S. Domestic Law).
However, under the Germany-U.S. Estate and Gift Tax Treaty, only Germany may tax an IRA/401-k inherited from a nonresident alien, whose fiscal domicile in the meaning of the Treaty is in Germany.
Note: In the case of a non-resident decedent, a U.S. financial institution can refrain from distributing assets until a U.S. federal transfer certificate is issued. Under certain circumstances, this requirement, which stems from risk aversion, can be waived. For example, this demand may be waived when the beneficiary is the spouse of a U.S. citizen.
State Estate and Inheritance Taxes
Some U.S. States also have their own inheritance tax or estate tax. The most populous states in the U.S., California, Florida and Texas, do not have a state estate tax. However, many states maintain an estate tax scheme. The exemption amounts and the nature of the tax varies significantly by state. Exemptions amounts vary significantly. New York provides for an exemption amount of $6,940,000, which is nearly half of the federal exemption amount, but still higher than many east coast states. Another wealthy east coast state, Massachusetts, provides for an exemption significantly lower at $2,000,000. New Jersey follows a similar scheme to many civil law countries and provides for exemptions based on the relationship between the decedent and the beneficiary. In sum, a U.S. decedent’s state residence could have significant ramifications in the form of exposure to state estate tax.
German Inheritance Tax
German inheritance tax (Erbschaftsteuer) is triggered by an IRA distribution as it is deemed an acquisition upon death in accordance with Section 3 (1) No. 4 of the German Inheritance and Gift Tax Act (ErbStG). The capital value on the date of death is decisive. If the IRA is rolled-over to the surviving spouse, the German inheritance tax can be paid annually in advance on the annual value instead of the capital value at the discretion of the beneficiary, See § 23 ErbStG.
Acquisitions by individuals within the meaning of § 46 et seq. of SGB VI (German Social Security Laws), e.g. the spouse, are inheritance tax-free if they derive from employment and the foreign retirement plan is comparable to a German plan. While we think that a 401-k and roll-over IRAs are typically comparable to a German retirement plan, the practice of the tax authorities is rather restrictive and there is often substantial resistance to overcome.
Germany is not barred from imposing German inheritance tax on distributions from an IRA/401-k to a person, whose fiscal domicile is in Germany. See Art. 11 1. b) of the Germany-U.S. Estate and Gift Tax Treaty.
The acquisition must be reported to the tax office within 3 months in accordance with § 30 ErbStG.
Our services: We prepare the reporting letter and, if an inheritance tax is requested, prepare the German inheritance tax return.
German Income Tax
In its ruling of 28.10.2020, X R 29/18, BStBl. II 2021, page 675, the German Federal Fiscal Court (BFH) held, that lump-sum payments during the lifetime of the beneficiary from a "401(k) pension plan" are deemed to be other income in the meaning of § 22 no. 5 sentence 1 of the German Income Tax Act (EStG) and that the income is taxable in accordance with § 22 no. 5 sentence 2 EStG in the amount of the difference between the lump-sum payment and the contributions, provided that the taxpayer was not a German tax payer when he made the contributions. If the benefit is paid out as a lifelong pension (which only spouses have been able to choose since 2020), the ruling is likely to result in taxation in accordance with § 22 no. 5 sentence 2 letter a in conjunction with § 22 no. 1 letter a double letter bb EStG with the income portion.
Update: By Annual Tax Act 2024 the legal situation prior to the BFH ruling of 28 October 2020, X R 29/18 was restored. Consequently, some lifetime distribution will now be taxed just like a German tax-deferred pension plan. The change could also have consequences for the taxation of the death benefit of a 401k and IRA.
Whether death benefits from an IRA or 401-k are taxable under German law was not the subject of the decision. We have opined t that there are supported argument against taxing of the death benefit,at least in the case of a lump sum distribution and the applicability of § 20 (1) no. 6 EStG in its current version. However, resistance from the tax authorities must be expected as this is a nuanced and complex argument
Our services: We welcome the opportunity to advise our clients and/or their advisors on the tax consequences of the acquisition on death and distributions and work towards the exercise of tax options under U.S. tax law on behalf of our clients. We also assist in the procurement of any necessary documentation.
Germany is not prevented by the Germany-U.S. Income Tax Treaty to tax distributions to the a beneficiary who has his/her fiscal domicile in Germany. If the distribution is also taxed by the U.S. (e.g. because the beneficiary is a U.S. citizen), double taxation is avoided by crediting the German tax against the U.S. tax. As the German tax on IRA/401-k distributions is typically lower than the U.S. tax, this typically results in no additional tax because of the beneficiary`s German residence.
Double taxation with income tax and inheritance tax
According to § 35 b EStG, a reduction in income tax may be granted if the income was subject to inheritance tax in the assessment period or in the preceding 4th assessment periods as an acquisition by reason of death. However, this presupposes taxation at the individual tax rate. As far as distributions from an IRA/401-k are taxed at the flat-rate of 25 % (Abgeltungssteuersatz), this is not the case. If the individual tax rate is to be applied, e.g. case of a role-over, a reduction in the tax is possible in accordance with § 35 b EStG is granted.
