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Basically, wife and I made low income in 2016, I have an inherited IRA now, and want to know if I should take a $9k chunk of it for 2016 (I have one day left to decide). If I do, it will be taxed at 10% because we're in that bracket--but I'll lose another ~14% in Premium Tax Credit for my Healthcare Marketplace-selected health insurance, so 24% tax. We don't plan on staying in this super-low tax bracket for 2017 and beyond.

If I take a $9k distribution now, can I offset my 2016 income with a $9k traditional IRA? Not a Roth IRA (because then I'd be paying the 24%), but a regular IRA. As I understand it, regular IRA contributions reduce your MAGI used for figuring the Premium Tax Credit. The $9k would go into the IRA before April (I don't have to rush to open it).

I'd then pay tax on that IRA when I withdrew the funds at retirement, when, I assume, I will be again in a low(ish) tax bracket (15% I'd guess?).

Upside: I may reduce taxes on $9k and save $810. Downside: Won't reunite with this money for 20+ years, so don't have added flexibility that I currently have with this inherited IRA. I don't need the $9k as cash, I don't think, and hope to never have to be in the position to cash out early and take the 10% tax penalty.

Am I thinking right?

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TL; DR version: What you propose to do might not save you taxes, and may well be illegal.

Since you mention your wife, I assume that the Inherited IRA has been inherited from someone other than your spouse; your mother, maybe, who passed away in Fall 2015 as mentioned in your other question (cf. the comment by Ben Miller above)? If so, you must take (at least) the Required Minimum Distribution (RMD) from the Inherited IRA each year and pay taxes on the distribution. What the RMD is depends on how old the Owner of the IRA was when the Owner passed away, but in most cases, it works out to be the RMD for you, the Beneficiary, considered to be a Single Person (see Publication 590b, available on the IRS web site for details). So,

Have you taken the (at least) the RMD amount for 2016 from this Inherited IRA? If not, you will owe a 50% penalty of the difference between the amount withdrawn and the RMD amount. No, it is not a typo; the penalty (it is called an excise tax) is indeed 50%.

Assuming that the total amount that you have taken as a Distribution from the Inherited IRA during 2016 is the RMD for 2016 plus possibly some extra amount $X, then that amount is included in your taxable income for that year.

  • You cannot rollover any part of the total amount distributed into your own IRA and thereby avoid taxation on the money. Note that it does not matter whether you will be rolling over the money into an existing IRA in your name or will be establishing a new rollover IRA account in your name with the money: the prohibition applies to both ways of handling the matter.

  • If you wish, you can roll over up to $X (the amount over and above the RMD) into a new Inherited IRA account titled exactly the same as the existing Inherited IRA account with a different custodian. If you choose to do so, then the amount that you roll over into the new Inherited IRA account will not included in your taxable income for 2016. To my mind, there is no point to doing such a rollover unless you are unhappy with the current custodian of your Inherited IRA, but the option is included for completeness. Note that the RMD amount cannot be rolled over in this fashion; only the excess over the RMD.

  • If you don't really need to spend the money distributed from your Inherited IRA for your household expenses (your opening statement that your income for 2016 is low might make this unlikely), and (i) you and/or your spouse received compensation (earned income such as wages, salary, self-employment income, commissions for sales, nontaxable combat pay for US Military Personnel, etc) in 2016, and (ii) you were not 70.5 years of age by December 2016, then you and your wife can make contributions to existing IRAs in your names or establish new IRAs in your names. The amount that can be contributed for each IRA is limited to the smaller of $5500 ($6500 for people over 50) and that person's compensation for 2016, but if a joint tax return is filed for 2016, then both can make contributions to their IRAs as long as the sum of the amounts contributed to the IRAs does not exceed the total compensation reported on the joint return. The deadline for making such IRA contributions is the due date for your 2016 Federal income tax return. Since your income for 2016 is less than $98K, you can deduct the entire IRA contribution even if you or your wife are covered by an employer plan such as a 401(k) plan. Thus, your taxable income will be reduced by the IRA contributions (up to a maximum of $11K (or $12 K or $13K depending on ages)) and this can offset the increase in taxable income due to the distribution from the Inherited IRA.

Since money is fungible, isn't this last bullet point achieving the same result as rolling over the entire $9.6K (including the RMD) into an IRA in your name, the very thing that the first bullet point above says cannot be done? The answer is that it really isn't the same result and differs from what you wanted to do in several different ways. First, the $9.6K is being put into IRAs for two different people (you and your wife) and not just you alone. Should there, God forbid, be an end to the marriage, that part of your inheritance is gone. Second, you might not even be entitled to make contributions to IRAs (no compensation, or over 70.5 years old in 2016) which would make the whole thing moot. Third, the amount that can be contributed to an IRA is limited to $5500/$6500 for each person. While this does not affect the present case, if the distribution had been $15K instead of $9.6K, not all of that money could be contributed to IRAs for you and your wife. Finally, the contribution to a Traditional IRA might be non-deductible for income tax purposes because the Adjusted Gross Income is too high; once again, not an issue for you for 2016 but something to keep in mind for future years. In contrast, rollovers from one IRA into another IRA (both titled the same) can be in any amount, and they can be done at any time regardless of whether there is compensation for that year or not or what the Adjusted Gross Income is or whether there is coverage by a 401(k) plan. There are no tax consequences to rollovers unless the rollover is from a Traditional IRA to a Roth IRA in which case, the distribution is included in taxable income for that year. What is prohibited is taking the entire amount of the $9.6K distribution from an Inherited IRA and rolling it over into your existing IRA (or establishing a Rollover IRA in your name with that $9.6K); ditto for some money going into your IRA and some into your wife's IRA. I expect that any IRA custodian will likely refuse to allow you to carry out such a rollover transaction but will be glad to accept 2016 contributions (in amounts of up to $5500/$6500) from you into existing IRAs or open a new IRA for you. The custodian will not ask whether you have compensation for 2016 or not (but will check your age!); it is your responsibility to ensure that you do not contribute more than the compensation etc. Incidentally, subject to the $5500/6500 maximum limit, you can (if you choose to do so) contribute the entire amount of your compensation to an IRA, not just the take-home pay amount (which will be smaller than your compensation because of withholding for Social Security and Medicare tax, State and Federal income tax, etc).

  • I don't understand. First you say money is fungible and I can deduct. Then you say I can't. This is critical to understand. Please help! – Manbatton Jan 1 '17 at 18:52
  • @Manbatton Please see the revised answer. – Dilip Sarwate Jan 2 '17 at 20:38
  • Thank you so much for the revised and even more thorough answer. I think in our case, the "fungible" new IRAs will work, but it's good to know all the details. – Manbatton Jan 13 '17 at 4:30
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If you have enough earned income to cover this amount you should be all set. If I understand you correctly you proposed two transactions. The first, a withdrawal from the beneficiary IRA. Some of which is an RMD the rest is an extra withdrawal of funds. Next, you propose to make a deposit to a combination of your IRA and your wife's IRA. As long as there's earned income to cover this deposit, your plan is fine.

To be clear, you can't "take a bene IRA and deposit the RMD to an IRA." But, money is fungible, the dollars you deposit aren't traceable, only need to be justified by enough earned income. A bene IRA is a great way to get the money to increase your own IRA or 401(k) deposits.

Further details - The 2016 contribution limit is $5,500 per person, so I did make the assumption you knew the $9000 deposit need to be split between the 2 IRAs, with no more than $5500 going into either one.

  • Joe, you might want to emphasize that if the proposed $9K is taken from the Inherited IRA, regardless of whether any part of it is an RMD, the OP cannot put $9K into his Traditional IRA (no matter from which checking account/savings account the "physical" dollars come from) ; the IRA contribution for 2016 is subject to the standard limitation: the smaller of $5.5K/$6.5K and earned income for 2016 to be contributed by Tax Day for 2016 in April 2017. In short, contributing $9K for 2016 to the OP's IRA is not permitted and deducting that amount on the 2016 tax return is not permitted either. – Dilip Sarwate Dec 30 '16 at 16:43
  • Joe, I am very confused by Dilip's post and his comment to yours. I wanted to open a brand new regular IRA for myself and one for my wife (each our first IRAs aside from my Continued RMD IRA now), though we have 403bs) sometime between Jan 1 and Apr 15 2016, and put about $4.25k into each, given we have earned income (truly earned) of about $8.5k this year (sad as that figure is!). I thought this would reduce our AGI for 2016 by 8.5k. Dilip's saying it won't work?? – Manbatton Jan 1 '17 at 18:57
  • I believe Dilip was making clear that you need earned income to take the IRA deduction. You can't deduct more than the earned amount. So withdrawing say $14k from the inherited IRA doesn't affect the amount you can deposit to the traditional IRA, still just the earned income amount. That was it, I think. – JoeTaxpayer Jan 1 '17 at 19:30
  • Thank you, Joe. Both your and his responses were very helpful. – Manbatton Jan 13 '17 at 4:31

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