Taxation of Distributions from an inherited IRA to a person Resident in Germany

IRAs are commonly used in estate and tax planning throughout the U.S. Accordingly, many German residents entitled to an inheritance with a U.S. situs will find that such an inheritance will include an IRA. Most U.S. residents and/or citizens will choose to treat the IRA as their own or roll it into an existing IRA. This option is often unavailable or is unattractive for those with limited ties to the U.S. Once a German resident determines how to treat their inherited IRA, they will need to assess the tax repercussions in the U.S. and Germany. This assessment will necessary require analysis of the Germany-U.S. Income Tax Treaty and the Germany-U.S. Estate and Gift Tax Treaty.

Options of a 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 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 l seek to be treated as a beneficiary and seek a distribution of the assets.

IRA Inherited from 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 Sec. 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 is progressive, the tax triggered by a lump sum distribution may subject the beneficiaries to the tax rate applicable to the highest tax bracket and the tax may be significant. 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.

U.S. Federal Estate Tax

In addition to federal income tax, a distribution from an inherited IRA can trigger federal estate tax and state inheritance tax. These taxes may be mitigated by the fact that many states do not have estate tax and the federal government provides for significant estate tax exemptions for the estate of U.S. citizens and residents. If applicable, income tax paid can be offset at least in part against the estate tax. If these exemptions are applied, taxation can be limited. Deceased nonresidents who were not U.S. citizens are subject to U.S. estate taxation with respect to their U.S.-situs assets. This includes the death benefit from an IRA (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 inherited from a nonresident alien.

German Income Tax

If the secondary beneficiary of an IRA has his fiscal domicile in Germany, only Germany may impose income tax (Einkommensteuer). See Art. 18 of the Germany-U.S. Income Tax Treaty. However, if the second beneficiary was a U.S. citizen, the U.S. may also tax the IRA distributions. See Art. 1 (4) and (5) of the Germany-U.S. Income Tax Treaty (“Savings Clause”). To what extent German income tax is assessed in addition to U.S. taxation has been a disputed issue until the federal fiscal court ruled on October 28, 2020, X R 29/18, that - in case of a lump sum distribution - only the difference between the contributions and the distributed amount should be taxed if the contributions were not deducted from any income taxable in Germany.

German Inheritance Tax

Germany may impose German inheritance Tax (Erbschaftsteuer) due to the fact that the beneficiary resides in Germany. See Art. 11 1. b) of the Germany-U.S. Estate and Gift Tax Treaty. In this case, Germany levies inheritance tax pursuant to § 3 Abs. 3 Nr. 4  of the German Inheritance and Gift Tax Act (ErbStG). See decision of the German Federal Fiscal Court dated June 15, 2016, file number: II R 51/14. However, if the beneficiary is the surviving spouse of the Decedent or a dependent/minor offspring of the decedent it is conceivable that transfers to these individuals would be tax exempt.

Double Taxation with German Inheritance and Gift Tax

Whether one taxable event can simultaneously trigger income and inheritance taxes is in contention. This issue is acute in terms of German domestic law as inheritance tax exemptions in Germany are significantly lower than in the U.S. Nevertheless, it is clear that German inheritance tax may be levied on the distribution from a tax deferred pension plan. If, following the opinion of the German fiscal authorities, the total distributed amount is taxed, a discharge under § 35 b EStG shall be granted.