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).

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