When Marvin Rotenberg sits down with people who have recently inherited a big-balance individual retirement account, they get an earful. Certainly Rotenberg, the director of individual retirement solutions at Bank of America, describes how stretching the account over the beneficiary's lifetime can create significant tax-deferred wealth. But Rotenberg also lets heirs know they're entitled to an income-tax deduction that could amount to nearly half-a-million dollars on a $1 million inherited account--if the original owner paid federal death tax. It's a break the client can use even if she chooses to empty the account to go partying with Paris Hilton.
Other scions are less fortunate when it comes to the itemized deduction for federal estate tax paid on traditional retirement-plan assets and other IRD--income in respect of a decedent. In fact, according to Michael Jones, a partner in the Monterey, Calif. accounting firm Thompson Jones LLP, "Missing this miscellaneous deduction"--allowed under the alternative minimum tax and not subject to the 2 percent-of-income floor that reduces most miscellaneous itemizations in the regular-tax system--"is consistently cited as one of the top mistakes return preparers make."
For the wealth manager, accountants' ignorance could well be bliss. Understanding IRD--both its income and deduction benefits--will not merely sharpen your financial planning calculations; it could land you a new client. Perhaps you notice that a prospect has not been taking the deduction. In that case, Rotenberg says, "you could recommend amending the last three tax returns to get a refund plus interest." Did someone say, "Trusted advisor?" Or perhaps it is your client who has passed away. Being the first professional to inform the beneficiaries about a handsome tax deduction could impress them. "It's a great entr?e with the new generation," says Rotenberg, who expects to be having more of these conversations in the near future. Effective January 1, non-spousal beneficiaries may roll employer qualified-plan assets over to an inherited IRA which they can stretch, thanks to the Pension Protection Act of 2006.
"IRD is taxable income you were entitled to receive before dying, but didn't," explains Gregg Parish, a professor of estate planning at the College for Financial Planning. Yet the income doesn't appear on your final income-tax return. Rather, it is taxed to the recipient--making it "in respect of" the decedent--who treats it the same way the decedent would have. Very important note: It is the IRD recipient who deducts the federal death tax it spawned, regardless of who paid the tax or when.
Ordinary income pent up in traditional IRAs and qualified plans tends to be the high-impact IRD, Parish says. Other common examples include interest accrued on bonds, declared dividends, a worker's final paycheck and deferred compensation. Ever popular annuities are also an IRD source, says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md. Growth in the contract is IRD. So is any additional death benefit paid to the beneficiary. Assume the decedent invested $50,000 in a contract with a cash value of $75,000 when he died. If the beneficiary receives $90,000 because of an enhanced death benefit, she has $40,000 of IRD--the difference between payout and basis--taxable when received, Kitces explains.
The annuity example illustrates another important rule: IRD items do not get stepped-up basis. "Therefore, the value shown on the estate-tax return for an asset won't necessarily be the inheritor's cost basis," Kitces says. "The estate may have valued a bond at $101,000. But if $500 is accrued interest, which is IRD, the bond only steps up to $100,500."
The no step-up rule also figures into analyzing the net unrealized appreciation (NUA) of employer securities held in a 401(k). Briefly, when rigid Internal Revenue Service procedures are followed and the plan allows it, a worker can take a distribution of his employer's stock from the plan at separation from service. This can be particularly profitable with low-basis positions.
Let's say a worker distributes shares which had cost him $10,000 when they are worth $100,000. After taxes are paid on the basis, the $90,000 growth--the NUA--qualifies for long-term capital gains treatment whenever the shares are sold. Yet NUA is income in respect of death. It doesn't step up, (IRS Rev. Rul. 75-125), Kitces says. If the stock's value is $200,000 at the investor's passing, the inheritor's basis is only $110,000--the decedent's $10,000 basis, plus the $100,000 rise between distribution and death--and the heir owes capital gains on the $90,000 NUA whenever he or she sells the securities, Kitces explains.
Now About That Deduction
No one knows why, exactly, the deduction for IRD-attributable estate tax is so neglected. Best guess: It's geared to the wealthy, so it's unfamiliar to many tax accountants, and estate-planning attorneys are not exactly rushing to inform them. To pick up the slack, advisors should ask specifically during new client intake whether any property that might be subject to IRD rules was acquired by inheritance, Kitces says. It's also smart to inspect the client's Form 1099-R from plan trustees and annuity companies, adds Jones. You might notice a decedent's name on the account, suggesting it was inherited. The "Distribution Code" could be a tip-off, too. "On the 2006 form, Code 4 entered in Box 7 means the distribution is exempt from the 10 percent tax on distributions before age 59 1/2 because the participant died," Jones says.
What you won't find anywhere is the client's deduction. It has to be calculated. "It's the difference between what the estate tax actually was, and what it would have been without the IRD," according to estate-planning maven Natalie Choate, an attorney with Bingham McCutchen LLP in Boston and author of Life and Death Planning for Retirement Benefits (Ataxplan Publications), now in its sixth edition.
Take a $3 million estate that includes a $1 million traditional IRA and no other IRD. The unmarried individual died in 2006, when the federal estate tax was a flat 46 percent of everything above the $2 million tax-free amount. Thus, the actual tax was $460,000--46 percent of the $1 million taxable estate. (We'll ignore state death taxes, even though they are important.) Now, consider the estate without the IRA. On $2 million, there is no tax. Therefore, the entire death-tax bill is attributable to the account. The beneficiary gets an eye-popping $460,000 itemized deduction that is not to be missed, although it is subject to the phase-out rules for such deductions. "Co-beneficiaries share the deduction among themselves proportionately," Choate says.
When the estate includes multiple IRD items, each is allocated a pro-rata share of the total death tax they all racked up, in proportion to their fair market values on the estate-tax return, Kitces says. Extending the previous example, assume the estate's total IRD remains $1 million, except now it consists of a $975,000 IRA (read: 97.5 percent of the total IRD) and $25,000 in dividends received after death from stock in a taxable account. Hence, 97.5 percent of the $460,000 deduction, or $448,500, goes to the IRA beneficiary, leaving $11,500 for the inheritor of the stock.
The Stretch IRA's Timing Conundrum
The deduction is taken when the income is reported--easy to compute when the heir empties the IRA in a single year. But what to do when the account is stretched over multiple years isn't clear, according to Christopher Hoyt, a professor at the University of Missouri School of Law in Kansas City. "Although there is a prescribed method for inheritors selecting an annuity payout of equal annual distributions, there is no law on how to calculate the deduction when the beneficiary withdraws a different amount each year," Hoyt says. It's an accounting dilemma: What portion of a partial withdrawal is the inherited account's original balance (which is IRD that allows a deduction), and what portion is subsequent investment profit (which is not)? In the absence of official guidance, at least two methods seem to have gained currency:
First is the aggressive front-loaded approach, which assumes the first dollars withdrawn are original-balance IRD, and that each IRD dollar carries a dollar of deduction. (See "Differing Deductions," page 27). In the example, as the first $460,000 is distributed from the account over time, the client takes a matching deduction. In the table, this is displayed for a beneficiary whose first required withdrawal is $40,984 in 2007. In the future, she will continue equating her tax deduction with her withdrawal until she has cumulatively claimed $460,000. One estate planner who utilizes this approach is Christopher Sega, a partner in the Washington, D.C.-based law firm Venable LLP. "The time value of money is such that in most cases, we prefer to take the deduction as soon as possible," says Sega. "It really depends on the heir's anticipated marginal tax rate."
Pro-rata, the other popular method, is serviceable when deductions are potentially more valuable to the heir in the future than in the present. In practice, the method has variations. As practiced by Bank of America's Rotenberg, the rate of estate tax paid on the inherited account is applied to each dollar withdrawn--46 percent of a $40,984 distribution warrants an $18,853 deduction. This spreads the deduction over time more slowly than does front-loading.
The pro-rata approach can also be useful for someone who has completely disregarded the deduction in years past. Generally, only the last three tax returns may be revised. Older ignored deductions are water under the bridge. Nevertheless, they must still be accounted for in order to determine how much of the original deduction remains available. The number will be larger if you reconstruct history with the pro-rata methodology, than it would be with front-loading.
For similar reasons a third method could be appealing, although Choate says she is unaware of anyone using it. In the LIFO-style approach, she explains, "distributions are assumed to come first out of post-death earnings. Only after those are exhausted are withdrawals deemed to be IRD" from the original account balance that garners a deduction. Choate says. This method delays the deduction the longest.
Every one of these methods clearly involves painstaking recordkeeping. A put off? Maybe. But remember, tax preparers may not be conscious of this deduction. "IRD really is an opportunity for the advisor to shine," Rotenberg says. "Get the accountant to handle it on an on-going basis, but you should be the one credited with mentioning it to the client in the first place."
Where should IRD go?
Without the right planning, high-net-worth clients could pay both estate and income taxes on assets bearing income in respect of a decedent. To avoid this trap, Gregg Parish of the College for Financial Planning suggests first finding a way--such as an individual retirement account, that doesn't trigger the income tax--to pay death taxes without dipping into IRD. Next, pass IRD to the spouse, either directly or in trust. "That way, the IRD can qualify for the marital deduction, which delays the estate tax until the survivor dies," says Parish, a professor of estate planning. Or the survivor might consume the IRD and cheat the death tax altogether.
Washington, D.C. attorney Christopher Sega advises beneficent clients to leave IRD to charity. The estate-planning documents of those who do so "provide that the bequest is to be satisfied with assets generating income in respect to a decedent," says Sega, a partner with Venable LLP. "On the other side of the coin, we remind clients not to fund their credit-shelter trust with an IRD item." This trust holds the death-tax-free portion of the estate. "That's a precious exemption. You don't want income taxes to reduce the amount in there," Sega says.
However, Boston estate-planning attorney Natalie Choate, of Bingham McCutchen, observes that there is one exception to that 'rule': "If the credit-shelter trust beneficiaries are very young, their ability to stretch payout over life expectancy can outweigh funding the trust with income-taxable dollars. In this case only," Choate says, "you should fund the credit-shelter trust with retirement assets that the beneficiaries can stretch."--ER
Eric L. Reiner is a freelance business writer in Boulder, Colo.