“Once thought to be relatively obscure, IRD deductions are becoming more common. Big-ticket IRD items such as distributions from IRAs, 401(k)s, 403(b)s, and other tax-sheltered retirement plans of affluent baby boomers have been growing in past decades and will be worth millions when owners bequeath them to estate beneficiaries. Distributions from these plans constitute gross income to the beneficiary and could be subject to marginal federal in come tax rates as high as 35%. Plan balances also are subject to estate tax rates as high as 48%—a double whammy. Together, these taxes can severely reduce the size of a beneficiary’s inheritance.”
Journal of Accountancy, April 2004, “Importance of IRD: greater diligence can help CPAs avoid costly tax return omissions.”
As stated above, retirement accounts are growing larger. It may seem crazy, but a large IRA could be subject to an 86% overall tax rate as shown below.
Mr. Smith is single and has a $4 million estate of which $1 million is an IRA. He has named his estate as his IRA beneficiary. He is in the 35% federal income tax bracket, 5% net state income tax, and in the 46% estate tax bracket. Taxes on his IRA are as follows:
Federal Income Tax $350,000
State Income Tax $50,000
Federal Estate Tax $460,000
Wait a minute, you say! That person does not really have an IRA of $1 million. Since he owes federal income tax at his death, why should he pay estate tax on something he really just owes to the government? That IRA, as far as the federal government is concerned really only has a value of $650,000 ($1 million less federal income tax of $350,0000) Right you are. Even Congress has a heart and does not think it’s right for people to pay estate tax on an amount that remains in their estate and is really accumulated income tax. So the tax code provides a deduction to the beneficiaries that will inherit the IRA. It’s called the deduction for income in respect of a decedent (IRD).
Here’s how it works in simplified manner. Each time the beneficiaries receive a distribution from the IRA, they will be entitled to also take a tax deduction equal to 46% of each payment. In effect, this deduction allows them to recover the estate tax paid on the accumulated federal income tax on the deceased’s IRA.
While it’s true that the IRA beneficiaries will qualify for recovery of the estate tax paid through the IRD Deduction (IRD), this tax deduction could be lost if:
- The beneficiaries don’t know to claim it.
- They don’t itemize deductions on their personal tax returns.
Therefore, the IRA in the above example is assessed with an 86% tax with possibly no offsets. Can this heavy tax be avoided? Yes. Estate taxes are always voluntary (one can gift the taxable portion of their estate to charity and pay no estate tax) or heavy taxes can be offset by life insurance1 as we will see later.
The above situation is the worst possible situation as the IRA owner has named his estate as beneficiary causing income taxes to be due sooner. By properly naming beneficiaries, the income tax could have been deferred for many years.