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Individual retirement accounts [superscript]1 can be one of the most significant portions of an individual's estate because they accumulate wealth on a tax-deferred basis. Contributions to regular IRAs are made before income is subjected to taxation, and the profits from investments are only subjected to taxation when distributed to the beneficiary. Thus, the longer an individual is able to keep assets in an IRA, the greater the potential for tax-deferred wealth accumulation. As a result, the beneficiary designation on an IRA is an important decision because it determines not only who receives the distributions, but also the period of time over which the IRA can be distributed. [superscript]2 Naming a nonresident alien (NRA), that is, a foreign individual, as the beneficiary can significantly complicate the distribution process by erecting legal and procedural hurdles that must be overcome before the NRA can receive distributions - hurdles that are absent if the beneficiary is domestic.
Therefore, your clients should avoid naming NRAs as beneficiaries of their IRAs whenever possible. [superscript]3 Nevertheless, NRAs are sometimes named as beneficiaries if a loved one lives abroad or if a named beneficiary relocates, and the beneficiary designation is never changed. In this circumstance, you should determine as soon as possible whether the NRA should begin the process of obtaining a U.S. individual taxpayer identification number (ITIN). As discussed in more detail below, the NRA may need an ITIN to: (1) reduce or eliminate a 30 percent withholding tax on the distributions; and (2) meet the identification requirements necessary to set up a rollover or inherited IRA, which provides beneficial tax treatment compared to a lump sum payment.
Avoiding Withholding Tax
Generally, NRAs are subject to a 30 percent tax on items of income they receive from sources within the United States that aren't derived from the conduct of a trade or business in the United States. [superscript]4 This tax is typically collected by way of withholding at the source. [superscript]5 Thus, the financial institution administering an inherited IRA for an NRA beneficiary is required to withhold 30 percent of each distribution, unless reduced by an income tax treaty. [superscript]6
Many of the income tax treaties that the United States has entered into follow the U.S. Model Income Tax Treaty (the...