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.
- 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.