Can I opt out of income taxes on inherited retirement benefits?

July 22, 2008 11:01 PM

Can I opt out of paying income taxes on inherited retirement benefits in the USA? I won't be filing a tax return, anyway.

I am a beneficiary of my deceased mother's state retirement plan. I have been given the option to either roll the amount over into an IRA (which I don't want) or take a direct payment, which appears to be subject to a 30% tax: 20% is automatic, and the other 10% appears to be related to electing not to put the money into an IRA.

If I choose a direct payment, the forms give me the following options:

A) "10% federal income tax withholding from any taxable portion of the accumulated account"; or

B) "no federal income tax withholding from any taxable portion of the accumulated acount"; option B continues, "If you request no withholding, you may still be responsible for payment of federal income tax on the taxable portion of your distribution. You may also be subject to tax penalties if your total estimated tax payments and withholding are not adequate to cover your tax liability."

Firstly, could someone please clarify the meaning of option B? I assume it means opting out of an automatic tax payment and agreeing to voluntarily pay it on my next federal income tax. However, I have been living outside of the USA and not filing tax returns for several years, and I intend to continue doing so. I am specifically confused about the ramifications of the last sentence considering, as far as the IRS is concerned, I will not have any income this year.

My real question is therefore: What, if any, consequences will I face if I simply take the maximum amount in cash and do not later declare it as income? If there is a penalty for this, is it subject to a statue of limitations? In other words, is this an easy way out or a really bad idea? I intend to remain invisible to the IRS for the forseeable future; will this ruin my plan?

Lastly, given that I am unlikely to ever live or retire in the USA, is there any other reason, specifically relating to taxes or avoiding such, that I should choose the IRA rollover option instead of a direct payment?

Thanks for any advise. I know I should see a financial advisor/accountant but I currently have major logistical obstacles in this regard.

posted by xanthippe to law & government (9 answers total)

I think there are a lot of missing details. For instance, are you an American citizen? How old are you? (This relates to the potential benefits of the IRA rollover option.) How much money are you talking about (roughly)? (This relates to whether you'd owe taxes at all.)

Firstly, could someone please clarify the meaning of option B? I assume it means opting out of an automatic tax payment and agreeing to voluntarily pay it on my next federal income tax. However, I have been living outside of the USA and not filing tax returns for several years, and I intend to continue doing so. I am specifically confused about the ramifications of the last sentence considering, as far as the IRS is concerned, I will not have any income this year.

But you *will* have income (this money) and the IRS will know. You're supposed to declare foreign-earned income (if you're a US citizen), which is abated somehow if you pay taxes on it overseas. I'm not precisely sure how that works. In any case, you are obliged to file a return and pay taxes on this money.

To answer your "real" question - yes, you would be engaging in income tax evasion - willfully not paying taxes. And because this is a transfer of monies with a lot of paperwork involved, you can be assured that the IRS will be informed. They can come after you for that until the end of time, legally. Penalties could be assessed on unpaid taxes, plus interest. Jail time is a technical possibility, however unlikely it may actually be.

You say you're "unlikely" to live or retire in the US, but things change. And looking down the road, I'd worry that one day (maybe today even, I don't know) just showing up in America and having your passport check may call this issue up. I'd weigh all this, plus a certain buffer of security, against the amount you think you'll get.
posted by Dee Xtrovert at 11:31 PM on July 22, 2008

Wow so it seems you're a US Citizen, who has been living outside the United States for some time, but not filing tax returns? This is what I've taken away from your question, but do feel free to correct if I'm mistaken.

Just to put what I'm about to post in context, I'm an American who has been living in Europe since 1997 (and filing taxes, but that's besides the point) and this is a variation of very common question / problem in ex-pat circles. First the preliminaries.

You, as an American citizen, are required to file an income tax return, every year OR an explanation of why you don't have to file (e.g., below the income threshold, etc). If you don't file the IRS can (and will, if they want to mess with you) audit that year any time they chose - there is NOT a statute of limitations. Once you do file they have (IIRC) three years to raise an issue / objection with the details in your stated return. In other words, the clock runs out for the IRS. Clearly its in your best interests to file, as IRS can only come back to you about information you've reported for three years. Just to summarise - once you do file, that clock is ticking (for them). Don't file, and that avenue for hassle is still open until the day you die (practicality is another issue I'll address later).

Now if you have any stateside assets they can levy "backup withholding", or a %28 forced deduction from and remittance to the IRS by any entity (e.g., brokerage, bank, etc) served this notice by the IRS. They can and will go after non liquid assets e.g., real estate, IP, etc., which on its own can trigger taxable events and cost even more money. Again the issue in the absence of you filing a return, the IRS will assume you owe money (otherwise, why wouldn't one file?). Until you file that return and they accept it, not owing any money is just your opinion.

Where it may get sticky for you travel. When your US passport expires, you'll naturally want to renew it. Since 911 Americans living abroad must renew their passports in their foreign country of residence. As per Federal Tax Law as it pertains to US citizens residing abroad, specifically Section 6039E of the Internal Revenue Code of 1986 "...applicants provide their name, mailing address, date of birth and social security number." Note that State directs any questions on this requirement to the IRS, and mentions a fine if you try to apply without providing your SS#.

When you do this, State will obtain confirmation from the IRS that you're current on your taxes; if you haven't filed for a certain period of time (not really sure what that is, but it ain't two years as I was that late once while in Bombay and I didn't have a problem) State will deny the renewal until IRS says its ok.

So unless you're a dual national, you're going to have issues with renewing your US passport if you don't file US tax returns.

But in general I'd advise you to not worry about passports and the future think about the now; the United States has what are known as Mutual Legal Assistance Treaties, or MLATs in place with a large number of nations globally.

From your profile I realise that you're in Oman, and while it appears there isn't such a treaty currently in place, keep in mind 1) this is just an internet source I've cited, and 2) things can and do change.

So, downside? Well, here in Western Europe collection wouldn't present an issue at all. In your part of the world while it appears there isn't an MLAT in place that simply means collection would be an extraordinary event. And in matters regarding international taxation, extraordinary should be read as expensive.

You haven't really cited the amount involved and I don't think you should. But realise that as the amounts increase so does the payback for the IRS in terms of collections.

I'm aware of folks here in Western Europe that have tried to dodge $20K payable on an inheritance, and ended up paying $50K or more by the time it was all done and dusted.

As the total amount inherited and the amount of tax payable increases, so does the IRS' motivation to collect and memory of your debt. They might forget $100 owed three years ago (big maybe) but as that debt grows they simply will not forget.

I spent long periods of time working on the ground in Africa, and the IRS was chasing a guy I worked with in Lagos of all places (he defaulted on student loans, and that caused the IRS to take notice that he hadn't filed for ten plus years). Now when I was working in Nigeria the delta region was the modern day equivalent of The Wild West, you had to wear sidearms and put up with all sorts of crap caused by being around folks that really don't care for you. Even so, the IRS was chasing people who owed them money in that (at the time) very lawless nation. So if the amounts are large enough, they will pursue and I suspect collection would not present much of a problem in The (relatively civil) Gulf. Especially so considering that entire geographic region is already under intense US scrutiny for money laundering / terrorist funding / etc.

Invisible to the IRS? I'm assuming you've got an SS#? Well, you might be invisible now, but be aware that once you register to collect that money owed you're no longer off their radar. Neither is your bank account you've paid that money into, whether deposited electronically or physically. Or any other bank you might transfer funds to.

And once you come to the IRS' attention they are going to inquire about your missing tax returns.

You can probably see where I'm going with this. Not filing and not paying? Bad idea.
posted by Mutant at 3:43 AM on July 23, 2008 [5 favorites]

Crap - when I copied and pasted this didn't come along for the ride - I'm very sorry to learn of your loss.
posted by Mutant at 3:46 AM on July 23, 2008

IANAL, but you should probably find one. "Some guy on AskMetafilter said it was okay" will not be an acceptable defense to a tax evasion charge and "It's okay, they'll never catch me" is a pretty low-integrity way to go through life. Anyway...

A general rule of thumb to keep in mind with respect to income tax is this: you have to pay it. If you think you found a clever new way to avoid paying your income tax, you're almost certainly wrong, definitely not the first person to try it, and someone else has probably gotten caught doing it before.
posted by toomuchpete at 5:52 AM on July 23, 2008 [1 favorite]

You don't say why you don't want the IRA, but you might consider the rollover option: it puts off the taxes until you reach retirement age, and the money grows untaxed. You can invest it in pretty much anything you want through a broker. You might be able to remove other money from your savings for immediate needs and keep this retirement savings intact.
posted by teaperson at 7:55 AM on July 23, 2008

I got audited in an identical inheritance situation. The 10% withholding in Option A will cover the penalty, but you will still have to declare the actual sum received and pay tax on it at your current withholding rate for the tax year in which you received the money.

As Mutant said, you will have to provide your SS# to get the money paid out to you from whatever institution holds the IRA, and financial institutions provide payout information electronically to the IRS.

I know you said it's logistically difficult to get legal advice at the moment, so the best I can offer is that you should do nothing with the inheritance until you have received counsel from an attorney admitted to the bar in the US who has estate experience.
posted by catlet at 4:06 PM on July 23, 2008

The IRA might not be totally useless to you. Some countries (eg, Canada) have tax treaties in effect with the US. In these countries, some American retirement savings vehicles (like IRAs) are recognized as tax-deferred savings vehicles and assets in the IRA can continue to grow tax-free (both in the US and in the country of your residence) until the cash is withdrawn. You can withdraw from an IRA in whatever country you please.
posted by crazycanuck at 9:07 PM on July 23, 2008

Ok. I have a probate lawyer; do I need his advice or an accountant or someone else?
posted by xanthippe at 9:14 PM on July 23, 2008

xanthippe -- "Ok. I have a probate lawyer; do I need his advice or an accountant or someone else?"

Accountant. And keep it simple at the outset; you don't want to roll over the IRA, you'd like to liquidate it and minimise your taxes while doing so. Don't introduce the international angle at all, as it simply isn't relevant to your goal.

While there are other vehicles (e.g., trusts such as an IRA Inheritor's Trust or Separate Share trusts I believe there are others) that help one minimise taxes, these structures introduce a level of complexity (cost) to what may at this stage be a totally manageable problem. Let your professional suggest the best way to achieve your goal.

Don't be surprised if your accountant asks to see recent tax returns. You may end up filing the last three (or so) years as part of your chosen professional's strategy to reduce your overall taxable obligation. You may be in a much stronger position than you realise as Americans living / working abroad are granted an annual tax free allowance of the first $85K earned, plus a range of deductions not available stateside.

Be honest about the state of your affairs (this person will help you), and this may turn out to be a total win/win - you've realised a cash infusion in a tax compliant manner, while removing a potential threat - "willful failure to file" - that may at some later date unnecessarily become a problem.

Best of luck!
posted by Mutant at 11:30 PM on July 23, 2008