You May Be Able to Reduce the Taxes from Inherited Assets - Rodgers & Associates

You May Be Able to Reduce the Taxes from Inherited Assets

Heirs of tax-deferred and employer-sponsored retirement accounts, such as IRAs, 401(k)s, and 403(b)s, often overlook a potential tax deduction. This deduction is called “Income in Respect of a Decedent,” or IRD, and it refers to untaxed income that a deceased person earned during their lifetime. The IRD is taxed to the individual or entity that inherits this income. In instances where the deceased’s estate is also subject to estate tax on the untaxed income, the benefi­ciary may take a tax deduction for the estate tax paid on the IRD.

While retirement accounts are common instances of IRD, there are several other IRD scenarios benefi­ciaries should famil­iarize themselves with.

Wages, salaries, and self-employment income: Bonuses for services rendered payable to a cash-basis decedent upon death are considered IRD if there was “substantial certainty” the bonus would have been awarded. Fringe benefits are considered IRD unless they would not have been included in the decedent’s gross income (as would be the case with payments for permanent loss or disfig­urement, for example). Post-death payments to a third party are considered IRD even though the decedent wasn’t entitled to them.

Unpaid interest and dividends: In order for the dividend to be considered IRD, the decedent must have been entitled to the dividend at the time of death. A deduction is permitted if the dividend’s record date precedes the date of death; if the record date is after death, the dividend is considered ordinary income to the beneficiary.

Deferred compen­sation plans: Deferred compen­sation can either be monies payable to an employee (the decedent), or monies owed to the employee’s benefi­ciaries, upon the employee’s death. To be excluded from IRD, the benefi­ciary must prove that the compen­sation wasn’t included in the decedent’s gross income when it was received.

Roth IRA distri­b­u­tions, for example, are excluded from IRD because the decedent paid taxes when they made contri­bu­tions to the plan. The distri­b­u­tions would not have been taxable to the decedent, and they’re not taxable to the benefi­ciary either. Additionally, retirement distri­b­u­tions that exceed the IRA owner’s taxable IRA balance (the value at the date of death, including appre­ci­ation and accrued income minus nonde­ductible contri­bu­tions) aren’t considered IRD.

Installment sale receipts: The benefi­ciary of an installment oblig­ation from a decedent should continue reporting the receipt of payments just as the decedent had. To calculate the IRD portion of the payment, take the gross profit ratio multi­plied by the annual payment and add any accrued interest of a cash-basis decedent not yet received.

If you are in the middle of settling an estate, you may be wondering which assets qualify as IRD. It might be helpful to know that, as an heir, you’ll likely receive most assets income-tax-free—after all estate and inher­i­tance taxes have been paid. If you do have to pay taxes on IRD assets, these assets are generally taxed at your ordinary income tax rate at the time you withdraw the funds.

However, suppose the decedent’s estate pays federal estate taxes on the IRD assets. In this case, you may be eligible for an IRD tax deduction based on the tax paid. (Note: Required Minimum Distri­b­u­tions, or RMDs, for the year the decedent died are considered part of their estate.) These estate taxes can be signif­icant, especially when the value of a deceased person’s estate exceeds $12.06 million (the threshold for 2022).

To under­stand how much tax has been paid, start by getting a copy of the decedent’s estate tax return (IRS Form 706) from the executor or admin­is­trator of the estate. Look to see if the estate has paid estate taxes. Then, take note of the value of any inherited items considered to be IRD. If estate tax was paid on these items, you can likely claim an IRD deduction.

Calculate how much estate tax was attrib­utable to these IRD items. You can claim this amount on your tax return using Schedule A for Itemized Deduc­tions. In the case of an IRA, you can only take the IRD deduction in the same tax year you withdraw money from the IRA.

Tax advisors and attorneys will be most focused on the transfer of assets and tax returns for the estate, and it’s easy for them to overlook potential IRD deduc­tions that benefit heirs. No doubt settling an estate can be compli­cated. Ask a financial adviser for assis­tance to make sure you don’t lose any IRD deduc­tions in the process.

Rick’s Tips

  • An IRD deduction may reduce the income tax owed by benefi­ciaries on certain inherited assets.
  • If taxes are owed on IRD assets, these assets are generally taxed at the beneficiary’s ordinary income tax rate at the time they withdraw funds.
  • If the decedent’s estate has paid estate tax on IRD assets, benefi­ciaries may be able to claim an IRD deduction.

Origi­nally Posted on December 19, 2012