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Retirement Perspectives

While Congress debates various tax reforms, don’t forget about a tax break that already exists for certain heirs.

For all the headlines about baby boomers being woefully unprepared for retirement and possibly paying  more federal taxes on retirement plan distributions, there is a large tax break available to people who inherit IRA or 401(k) plan assets—and most taxpayers aren’t even aware of its existence. It’s called “Income in Respect of a Decedent” (IRD), and it’s worth a closer look by advisors and clients alike. 

We’ll address further this often-missed tax break from the Internal Revenue Service in a moment, but first, here’s some background. Beginning in 1918, all inherited assets received a step-up in basis for income tax purposes. This meant that the market value of an asset at the owner’s death became its cost basis for whoever inherited that asset. In addition, beneficiaries paid no income tax on the value of the property they inherited. In 1934, however, lawmakers decided that certain items of income should not receive a step-up in basis; thus, the IRD was introduced. There were no IRAs at that time, and little did officials know the amount of income tax that would one day be generated by their IRD concept.

As tax-advantaged accounts, IRAs and other retirement programs are generally first subject to ordinary income tax when there is a distribution of funds from an account. The rules governing taxation of distributions generally are the same for the account owner, and upon his or her death, the account’s beneficiaries. In other words, beneficiaries absorb the income tax liability on the benefits they’ve inherited. But the estate of the deceased IRA owner is responsible only for the income-tax liability on distributions. Some beneficiaries may get a double whammy: they not only pay income tax on the distribution but also estate taxes over a certain amount.

In other words, an inherited IRA retains the same makeup as it would have if the decedent were alive to receive it. IRAs potentially are subject to double taxation, as their value is includible in the estate and counted as earned income. How? When a taxable IRA is inherited, the beneficiary who subsequently takes distributions pays income tax just as the IRA owner would have had he or she lived.  

Being Fair to Heirs
Does that double taxation sound unfair? Well, there’s some good news for retirement-plan beneficiaries: Section 691(c) of the Internal Revenue Code allows an IRA beneficiary to claim a tax deduction for assets that are classified as IRD. Strange as it may seem, the IRS does not explicitly define IRD. Instead, it’s referred to as “amounts to which a decedent was entitled as gross income, but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year” (IRS Regulation Section 1.691(a)-1(b)). By this reckoning, IRD is income that is owed to a decedent at the time he or she died.

Claiming an IRD Deduction
An IRA beneficiary could claim an IRD deduction at the time of the distribution from the IRA to the extent of any federal estate taxes that were caused by the inherited IRA. If the IRA generates an estate tax in the estate of a decedent, Section 691(c) allows the beneficiary taking a distribution from the retirement plan to deduct against the distribution the portion of the federal estate tax attributable to the IRA in the decedent’s estate.

Although Roth IRAs are subject to estate taxes, beneficiaries of Roth accounts usually do not qualify for IRD deductions. This is because Roth IRA distributions are not subject to income tax. However, if a Roth IRA beneficiary takes a “non-qualified distribution,” he or she could apply for the IRD deduction—but only from the portion of the distribution considered earnings.

IRD items (along with other estate assets) eventually will be distributed to the beneficiaries of the estate. While the beneficiaries receive, income-tax free, most of the assets of the estate, IRD assets (such as IRAs) generally are taxed at beneficiaries’ ordinary income tax rates. However, if a decedent’s estate has paid federal estate taxes on the IRD assets, a beneficiary may be eligible for a tax deduction under Section 691(c) based on the amount of estate tax paid. The IRD deduction is used to reduce the beneficiary’s income tax on withdrawals made from the IRA. It’s important to note that the IRD deduction is determined solely on federal estate taxes, not by any state estate tax liability.

When Estate Taxes Apply  
For advisors, the key is to determine whether or not your client paid estate taxes in 2017. In 2017, estates valued at less than $5.49 million will not be subject to a federal estate tax. Estates greater than $5.49 million, though, will be subject to a top tax rate of 40%. If estate tax was paid on an inherited IRA or 401(k), it is likely that the holder can claim the IRD deduction. The proper place to record this deduction is within the section Schedule A, of Form 1040, as a “miscellaneous itemized deduction,” not subject to the 2% of adjusted gross income (AGI) offset.

The IRS does not offer any dedicated forms for claiming the deduction. Instead, we suggest reading the IRS publication, “Survivors, Executors, and Administrators,” for more information and examples regarding calculation of the IRD deduction.

Again, not every beneficiary can claim the IRD deduction. If the estate is not subject to federal estate taxes then no IRD deduction is available.

Other IRD Applications
Here, we’ve described an IRD strategy using an IRA as the focal point. There are number of other retirement assets whereby an IRD may be applicable, including 401(k) plans, along with most other retirement plans that house pretax assets. The list of IRD assets includes, but is not limited to, deferred compensation, employer nonqualified stock options, nonqualified deferred annuities, and net unrealized appreciation (NUA) on company stock in retirement plans. (For more information on NUA, see here.)  

The Bottom Line
Partnering with a tax professional will provide valuable assistance in calculating, and claiming, the IRD deduction. This often overlooked deduction could result in sizeable tax savings, which could provide a measure of comfort for current retirement accountholders—and their prospective heirs.

If you have any questions about this or another retirement topic, please email Brian at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Income in respect of a decedent (IRD) is money that was due to a decedent and will pass through to the recipient or estate as income during that tax year. The recipient (beneficiary) must declare the money as income in respect of a decedent (IRD) for any year in which income is received.  A few examples of IRD include retirement plan assets, IRA distributions, unpaid interest and dividends, salary, wages, and sales commissions. Items of IRD, along with other estate assets, are eventually distributed to the beneficiaries of an estate. While the beneficiaries receive most assets of the estate income tax free, IRD assets are generally taxed at beneficiaries’ ordinary income tax rates. 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.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan provides small employers with a simplified method to contribute toward their employees' and their own retirement savings. Employees may choose to make salary reduction contributions and the employer is required to make either matching or nonelective contributions. Contributions are made to an Individual Retirement Account (IRA) or annuity set up for each employee (a SIMPLE IRA). A SIMPLE IRA plan account is an IRA and follows the same investment, distribution and rollover rules as traditional IRAs.

SEP IRA—A Simplified Employee Pension Plan is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP IRA plan for your business, you and any eligible employees establish your own separate SEP IRA; employer contributions are then made into each eligible employee's SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

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