The Tax You Didn’t Know You’d Pay—And How to Avoid It

Written by: Paul D’Alessandro and Greg Ring

Tax season can bring a lot of stress and anxiety for many Americans; however, it is an unavoidable part of life that we all must navigate. You are done compiling tax documents and receipts. You are trying to recover emotionally from the sting of sending your hard-earned dollars off to Washington, D.C. and your local government.

But what if we told you that there are taxes that may be optional? In fact, for most Americans, the highest tax bill they will pay in their lifetime could be avoidable.

How can this be? What taxes am I paying unnecessarily? And why on earth would I do that? These may be the types of questions running through your mind right now. Let’s see if we can help.

The highest tax bill you might pay in your lifetime is not widely known and could come as a rather unpleasant surprise if you are not prepared for it. This tax is called the Income in Respect of a Decedent, or “IRD” tax. At IPS Philanthropy Architects, we often refer to it as the “Most Overlooked Tax in America” – and for a good reason!

This tax does not relate to income, capital gains, or an estate. Rather, it is the tax most people pay on their IRAs and 401(k)s – taxes postponed when you originally funded those accounts.

Consider this hypothetical scenario. Joe and his wife, Cindy, are a middle-class America couple with three grown children.

Joe has worked hard throughout his career and has diligently stowed away pre-tax dollars into his IRA account. Although Joe and Cindy do not have many other assets, the IRA account has grown over the years and now holds $500,000. Perhaps their largest, single asset.

When Joe dies, he can pass the IRA to Cindy tax-free. However, when Cindy dies, their children will likely be required to pay a hefty tax bill on those funds. In this case, possibly $200,000 or more!

Since Joe and Cindy otherwise do not have an estate tax issue, this could easily be overlooked. Concerning, to say the least, right?

Well, here is the good news! In addition to being the “Most Overlooked Tax in America,” this particular tax is often, unlike our annual income tax, completely optional!

IPS Philanthropy Architects can help you understand more about these taxes and how to reduce or even eliminate them in favor of children and charity. Now is a great time to look at IRAs or 401(k)s to see if you can opt out of the IRD taxes.