IRD - Income in Respect of a Decedent...
Don't Lose that Tax Deduction!
What is IRD?
When you inherit an IRA, qualified retirement plan, or nonqualified annuity, you
typically receive income that the decedent had a right to during his or her
lifetime but was not taxable to the decedent because the income was not
distributed. That income is known as income in respect of a decedent, or "IRD".
Generally, persons do not owe income tax on inherited property; however, certain assets (such as IRAs, qualified
retirement plans, and annuities) are an exception to this general rule because
they include the right to receive income in respect of a decedent (IRD). IRD
is, therefore, income that the decedent had a right to during his or her lifetime but which
was not taxable during the decedent’s lifetime because the income was not
distributed before the decedent's demise.
Why is IRD subject to double (income & estate) taxation?
IRD may be subject to both income tax AND estate tax; however
Internal Revenue Code Section 691(c) offers some relief. Under 691(c), your
beneficiaries are entitled to an income tax deduction for the estate tax paid on
IRD.
IRA example: Dad contributed $100,000 (pre-tax) to an IRA several years
ago. At his death, he left the IRA (now valued at $125,000) to Jan. If Jan
withdraws the entire IRA, she will owe income tax on the full $125,000 IRA. The
entire $125,000 is IRD.
Nonqualified annuity example: Dad purchased a $100,000 nonqualified
annuity several years ago. At his death, he left the annuity (now valued at
$125,000) to Jan. If Jan withdraws the entire annuity, she will owe income tax
on the $25,000 ($125,000 current value less $100,000 Dad's initial purchase
premium) of annuity earnings. The $25,000 of annuity earnings is IRD.
Why is this double taxation?
For wealthier individuals, income in respect of a decedent can be
subject to both income tax AND estate tax. Let’s assume Dad is single with an
estate of $2,200,000 (including a $200,000 IRA).
Estate Tax:
After subtracting his $2,000,000 estate tax exemption, only
$200,000 of Dad's $2,000,000 estate is subject to estate tax.
$2,200,000 Taxable estate
$2,000,000 Estate tax exemption
$ 200,000
Dad’s estate will owe estate tax of approximately $90,000 ($200,000 x 45% estate
tax = $90,000).
Income Tax:
Keep in mind that Dad's IRA is also subject to income tax.
Assuming that the beneficiaries of Dad's IRA are in the 35% federal income tax
bracket, they will owe $70,000 of federal income tax on Dad's IRA, in addition
to any state income tax that may apply.
How does the 691(c) "rescue" deduction work?
Internal Revenue Code Section 691(c) gives your beneficiaries an
income tax deduction for the estate tax paid on income in respect of a decedent
(IRD). To determine the amount of this deduction, you’ll need to isolate the
amount of estate tax that was paid on the IRD. To do this, first calculate the
estate tax due on your estate. Then, determine your estate tax liability if the
IRD were excluded from your estate.
Dad's estate tax liability was $90,000 (see above).
Dad's estate tax liability...without IRD: If the $200,000 IRA were
subtracted from Dad's estate, federal estate tax would not have applied since
his estate would not have exceeded his $2,000,000 estate tax exemption.
The deduction amount: Dad’s beneficiaries are entitled to an income tax
deduction for the $90,000. Thus, whoever receives the IRA and pays the income
tax on the IRA distributions would receive an income tax deduction of $90,000.
If Dad’s beneficiaries are in the 35% federal income tax bracket, the 691(c)
deduction could put $31,500 ($90,000 x 35% income tax deduction) back into their
pockets.
What if the IRD is divided among multiple beneficiaries? If Dad were to leave
his IRA to his two children in equal shares, each child would be entitled to 1/2
of the $90,000 691(c) deduction ($31,500 divided by 2).
Are there limitations on the 691(c) deduction? Yes. This deduction is typically
claimed on Schedule A (IRS Form 1040) as a miscellaneous itemized deduction;
however, unlike other miscellaneous itemized deductions, it is not subject to
the 2%–of–AGI (Adjusted Gross Income) floor. If the beneficiary does not have
sufficient deductions to itemize (in other words, if the beneficiary takes the
standard deduction), the 691(c) deduction is of no use. In addition, if the
beneficiary has significant income, a portion of his or her itemized deductions
(including the 691(c) deduction) may be phased out.
Are state death taxes deductible? Any state death tax paid is not deductible on
an individual’s federal income tax return. The 691(c) deduction applies only
to federal estate tax paid on income in respect of a decedent (IRD).
