Reducing Taxes on an Inherited IRA - Rodgers & Associates

Reducing Taxes on an Inherited IRA

Reducing Taxes on an Inherited IRA

Have you recently inherited an IRA account? Did you know that the IRD deduction may help reduce the income tax you owe on taxable distri­b­u­tions? Income in respect of a decedent (IRD) is income that was owed to a decedent at the time he or she died but they hadn’t paid income taxes on Items of IRD, along with other estate assets, are eventually distributed to the benefi­ciaries of an estate. Examples of IRD include:

Wages, salaries & 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, such as payments for permanent loss or disfig­urement. Post-death payments to a third party are classified as IRD even though the decedent was not entitled to them.

Unpaid interest and dividends: Decedents must be entitled to the dividend at death for the dividend to be considered IRD. A decedent would be entitled if the record date of the dividend precedes the decedent’s date of death. If the record date is after the date of death, dividends are considered ordinary income to the decedent’s beneficiary.

Retirement account assets & deferred compen­sation plans: Deferred compen­sation can either be monies payable to the employee as well as monies payable to an employee’s benefi­ciaries upon the employee’s death. To be excluded from IRD, the benefi­ciary must prove that the compen­sation would not have been included in the decedent’s gross income when received. For example, Roth IRA distri­b­u­tions would not have been taxable to the decedent and thus are not taxable to the benefi­ciary, because original contri­bu­tions to the plan were not tax deductible. In addition, retirement distri­b­u­tions that exceed the IRA owner’s taxable IRA balance (the value at date of death, including appre­ci­ation and accrued income less nonde­ductible contri­bu­tions) are not considered IRD.

Installment sale receipts: The recipient of an installment oblig­ation from a decedent would continue reporting the receipt of payments just as the decedent had. The IRD portion of an installment sale payment should equal the gross profit ratio multi­plied by the annual payment, plus any accrued interest of a cash-basis decedent not yet received.
The heirs receive most assets of the estate income-tax free and after all estate and inher­i­tance taxes have been paid. IRD assets are generally taxed at benefi­ciaries’ ordinary income tax rates when they withdrawal the funds. However, if a decedent’s estate has paid federal estate taxes on the IRD assets, a benefi­ciary may be eligible for an IRD tax deduction based on the amount of estate tax paid. This can be a valuable tax deduction that many heirs miss out on. Best of all, the IRD deduction is not subject to the 2% floor, as are other miscel­la­neous itemized deductions.

With tax advisors and attorneys focused on the estate-tax return and the transfer of assets, it is easy to overlook the potential for heirs to benefit from IRD deduc­tions. Settling an estate can be compli­cated. Ask your financial adviser to make sure the IRD deduction does not get lost in the process.

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 paid an estate tax (for 2012, estates valued at less than $5.12 million will not owe estate tax). Then, take note of the value of any items of IRD you inherited. If estate tax was paid on those items, it is likely that you can claim the IRD deduction.

Calculate how much of the decedent’s estate tax was attrib­utable to the items of IRD that you inherited. This amount can be claimed on your tax return. You must itemize deduc­tions by filling out Schedule A, Miscel­la­neous Itemized Deduc­tions, on IRS Form 1040. You must claim the IRD deduction in the same tax year in which you actually received the income.

Rick’s Tips

  • The IRD deduction can reduce the income tax benefi­ciaries may owe on certain inherited assets.
  • If there are multiple benefi­ciaries and each benefi­ciary received only a portion of the decedent’s IRD assets, the benefi­ciaries could claim only their propor­tionate share of the IRD deduction amount.
  • If the decedent’s estate did not pay estate tax on the IRD assets, then the benefi­ciaries can claim no IRD deduction.