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Tax Savings for Retirement Plan Beneficiaries

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

One of the biggest impediments to obtaining wealth is taxes. Many individual retirement beneficiaries may be missing out on a huge tax break because they have never heard the words Income in Respect of the Decedent (IRD). This tax break gets missed by most individual retirement plan beneficiaries because of the fragmented process of settling an estate and preparing individual income taxes. Typically the two functions are handled by two different professionals and the info rmation may never get passed along or it might just flat out be missed.

Income in Respect of a Decedent

As indicated in IRS Reg. 1.691 (a)-1 the term “income in respect of a decedent” refers to those amounts to which a decedent was entitled as gross income, but which were not properly includible in computing taxable income for the tax year ending with the date of his or her death or for a previous tax year under the method of accounting employed by the decedent. Examples of IRD include IRAs, 401 (k) plans, and annuities.

IRD items are includible in taxable estates or those estates that have assets in excess of $1,500,000 in 2004. These assets would then be subject to estate taxes which can be as high as 48%. The beneficiary of retirement plans would then be subject to income tax on the assets when the funds were withdrawn from the account (the IRD item) which could be as high as 35%, which is the top marginal tax bracket in 2004. If an estate and individual beneficiary are in the highest tax bracket, the combined effects of these taxes in excess of the $1,500,000 exclusion are taxed at 83%.

Congress has provided a tax break for the federal estate taxes paid on IRD items. The deduction is claimed on the beneficiary’s personal tax return as a miscellaneous itemized deduction. It is not subject to the 2% Adjusted Gross Income limitation nor is it subject to the Alternative Minimum Tax.

Calculating the Income Tax Deduction

In order to calculate the income tax deduction available to a beneficiary you must determine how much estate tax is attributable to the IRD items. Source: CCH Estate Planning Review Volume 30, #5 May 20, 2004

Calculation of Code Sec. 691c Deduction

  With IRD Itmes Without IRD Items
Gross Estate $3,800,000 $2,700,000
Less:  
Administration Expense $100,000 $100,000
Adjusted Gross Estate $3,700,000 $2,600,00
Less:    
Allowable Deductions $200,000 $200,000
Taxable Estate $3,500,000 $2,400,000
Tentative Federal Estate Tax $1,500,000 $972,800
Less:    
Applicable Credit Amount $555,800 $555,800
Less:    
Estate Death Credit $57,300 $32,700
Federal Estate Tax Payable $887,700 $384,300

The federal estate taxes attributable the $1,100,000 of IRD items is $503,400 which is the amount available for the IRA beneficiary to use as a miscellaneous itemized deduction. The retirement plan beneficiary takes the IRD deduction as he/she withdraws from the retirement account/annuity. If there was no federal estate tax due on the decedent’s estate than there is no IRD deduction available.

Summary

Seymour Goldberg who frequently lectures on IRAs and other retirement planning issues says: “the potential monetary loss to taxpayers from ignoring this deduction could be huge. Based on just the amount of money held in deferred retirement accounts by those persons in the highest tax (and potentially estate tax) brackets, the figure could easily be in the billions and possible even trillions.”

If you have inherited any type of retirement account such as an annuity, 401(k) plan, or IRA make sure you are asking the right questions in regard to income in respect of the decedent. If you do not ask the question chances are the deduction may be lost without anyone ever advising you otherwise.