By Maurice R. Kassimir, Tonia Sherrod, and Melvin L. Maisel
Taking the Bite out of Estate and Income Taxes
Many people think of charitable giving as an effective way to minimize estate taxes for their heirs. But for some types of assets, taxpayers may want to find alternative ways of accomplishing philanthropic objectives: Taking full advantage of the deduction for income in respect of a decedent (IRD) under IRC section 691(c) can significantly preserve estate assets for heirs.
By filing the correct beneficiary designations, making the right distribution elections, implementing a minimum distribution plan, funding for the inevitable estate tax through gifting or life insurance, and taking advantage of the section 691(c) deduction, the participant and the designated beneficiaries can extend the distribution of the retirement assets over their full life expectancies. Further planning in how distributions are taken can allow a family to preserve a valuable asset without the onerous income tax and estate tax consequences.
Most articles about the taxation of qualified retirement plan assets and IRA accounts emphasize ďdouble taxationĒ: the estate taxes and income taxes imposed on these assets upon death which, without planning, can deplete them by more than 80%. To avoid the double tax burden, many taxpayers designate a charity as beneficiary, because the charity can receive the retirement assets income tax-free and the estate can deduct the charitable contribution. However appealing on the surface, charitable bequests of IRD assets can have unintended negative results. More sophisticated planning will result in the retirement assets passing to the participantís heirs without reduction for estate tax and with minimized depletion for income tax. Understanding the planning techniques that are available turns the onerous income tax and estate tax burden of income in respect of a decedent (IRD) into an advantage.
Tax Planning During the Participantís Lifetime
IRD is unrecognized and untaxed income originating in periods prior to an individualís death. This article focuses on IRD associated with qualified retirement plans and IRAs (excluding Roth IRAs) where the spouse is not the designated beneficiary; however, IRD assets can also include the following:
The minimum distribution rules for qualified retirement plans and IRAs allow participants to maximize the tax-deferred growth associated with these special assets (which are also protected from creditors) and to pass along these benefits to their spouses, children, or grandchildren.
A designated beneficiary is defined as an individual or a trust that meets certain criteria. A nonqualifying trust, charity, estate, or business entity would not be considered a designated beneficiary. Only a designated beneficiary can defer the payment of income tax after a participantís death.
Due to the tax benefits, retirement accumulations may be the most valuable assets that can be bequeathed. If the taxpayer files the proper beneficiary designations and makes the correct distribution elections, the minimum distribution rules can allow the participant and the designated beneficiaries to extend the distribution of the retirement assets over their joint life expectancy. This results in less of the assets being distributed each year, allowing more of the assets to continue to grow tax-deferred.
This option is not available, however, if the participant names as beneficiary a charity, the estate, or a nonqualified trust. In these cases, only the participantís life expectancy can be used to determine the minimum amount that must be distributed. In every situation, a single-life expectancy distribution is greater than a joint-life expectancy distribution. Therefore, if a charity is named as beneficiary, significantly more assets must be distributed annually during the participantís lifetime than if an heir had been named. In fact, if the participant lives beyond a normal life expectancy, the vast majority of the retirement assets will have already been withdrawn through distributions, leaving very little for the charitable beneficiary.
For example, if a 70-year-old participant with a $1 million IRA designated a charity as the beneficiary of her account and died at age 85, and the funds were invested at 8% per annum, the participant would have to withdraw $1,416,446 in minimum distributions during her lifetime, leaving only $769,285 for the charity. If the participant were to withdraw distributions in excess of the minimum, even less would remain for the charity.
If the same participant designated her 35-year-old son as beneficiary and elected to have her minimum distributions taken out over the term determined by her and her sonís joint life expectancy, upon her death only $1,115,966 would have been withdrawn and $1,541,000 would remain in the account to grow tax-deferred and be distributed to the son over his remaining life expectancy. The $1,541,000 is includable in her estate and subject to estate tax. If the son lives to age 82, he will have withdrawn $7,171,086 of minimum distributions during his life. Naming a charity as a beneficiary eliminates these potential distributions to the son. Clearly, many will prefer to preserve the retirement assets for their family if they can satisfy their charitable goals in other ways.
While retirement assets cannot be excluded from a decedentís gross estate, they may be preserved for the intended beneficiaries. Upon death of a married participant, the retirement assets will not be subject to estate tax if the surviving spouse is the designated beneficiary. However, if an unmarried participant leaves the assets to a noncharitable beneficiary, the account will be subject to federal and state estate taxes, which can reach as high as 55%. Furthermore, a retirement asset used to satisfy its portion of the estate tax will be subject to immediate income tax. For the typical high-net-worth individual, the combined federal and state marginal income tax bracket prior to the IRD deduction will be 45%. The combined effect of the estate tax and income tax on the retirement assets at the highest brackets prior to the IRD deduction would total 100%: 55% estate tax and 45% income tax.
For example, if a participant were to die with a $1 million IRA, the federal and state estate tax payable with respect to the IRA (in the highest tax brackets) would be as follows:
|Value of IRA||$ 1,000,000|
|Tentative tax (at 55%)||550,000|
|Less state death tax credit||(160,000)|
|Federal estate tax||390,000|
|State estate tax||$160,000|
|Total estate taxes||$550,000|
Without the IRD deduction, the balance of the IRA account would be needed for the income tax liability. However, using the IRD deduction can reduce the combined effect of the income tax and estate tax to approximately 82%, preserving 18% of the assets for the beneficiaries. The IRD deduction effectively reduces the marginal income tax bracket from 45% to 27.5%.
Using the previous example, this reduction can be illustrated as follows:
|Portion Withdrawn (100%)||$1,000,000|
|Less IRD deduction||(390,000)|
|Federal and state income tax (45%)||$274,500|
Therefore, using the IRD deduction, 17.55% of the account remains to be distributed to the beneficiary after the income tax and estate tax liabilities are satisfied:
|Value of IRA||$1,000,000|
|Less income taxes||(274,500)|
|Less estate taxes||(550,000)|
Additional planning can accomplish even more dramatic preservation of retirement assets. The $10,000 annual gift tax exclusion and the $675,000 lifetime exemption (which will increase to $1 million in 2006) can be gifted to a Crummey trust (an irrevocable life insurance trust that allows the beneficiaries to demand that the trustee disburse to them their portion of trust contributions within a specified period of time) or family partnership. These funds can then be invested in order to satisfy the projected estate tax obligation attributable to the retirement assets. Although problems can arise if the assets do not appreciate enough to cover the estate tax liability, a portion of the trust or partnership asset can be invested in single life or survivorship life insurance excluded from the taxable estate. Survivorship life insurance can also be purchased on a pre-tax basis using qualified retirement plan dollars or IRA rollover monies that have been transferred back to a qualified retirement plan.
In the preceding example, the fund balance upon the participantís death at age 85 is $1,541,000. The total estate tax attributable to the account is $824,550 (55% bracket). This amount can be provided for through a regular gifting program or through the acquisition of single or survivorship life insurance.
By providing for estate taxĖfree funds to satisfy the estate taxes attributable to the retirement assets, the minimum distribution plan (in the example, $7,171,086 of distributions) will be preserved. This will allow the entire date-of-death value of the retirement assets and all future appreciation to pass to the designated beneficiary, preserving a valuable asset for future generations.
Postmortem Income Tax Planning with the IRD Deduction
With proper planning, retirement assets may be protected from estate tax and income tax immediately upon the participantís death, but they will still be subject to income tax as they are included in the beneficiaryís income. The income tax effect can be minimized if the participant makes designations that allow the beneficiaries to minimize withdrawals over their life expectancy. In addition, if the beneficiaries are made aware of the IRD deduction, the income tax bracket with respect to the IRD will be reduced.
The IRD deduction is an often-overlooked but extremely valuable deduction for beneficiaries of retirement assets. The deduction allows IRD beneficiaries of all taxable estates to deduct from their share of IRD income the portion of the federal estate tax (after considering the federal estate death tax credit) attributable to the inclusion of the IRD in the taxable estate. The beneficiaries can use the deduction during their lifetime; if it is not fully used during the beneficiariesí lifetime, their beneficiaries can continue to use it.
For beneficiaries that die before withdrawing the entire account, the balance at death will be included in their estates. Because the IRD asset is taxed in both the parent participantís estate and the child beneficiaryís estate, the beneficiaryís beneficiary (typically a grandchild) may enjoy a double IRD deduction, alleviating the income tax cost even further.
Many individuals will directly designate as the beneficiaries of a retirement account either their grandchildren or a trust for the benefit of their grandchildren that is exempt from generation-skipping transfer tax. This planning has excellent results, primarily because of the substantially longer income tax deferral when the grandchildís life expectancy can be used. The annual minimum distribution after the participantís death will be reduced by 50% or more by designating a grandchild as beneficiary and the income tax liability will be lessened by having the minimum distributions taxed at lower brackets. Using the IRD deduction in such a scenario will even further lessen the impact of the income tax.
Calculating the IRD Deduction
To calculate the IRD deduction, the beneficiaries must first identify and total the value of the IRD items included in the decedentís gross estate (gross IRD). The gross IRD must then be reduced by any corresponding deductions in respect of the decedent to arrive at the net IRD. Next, the estate tax attributable to the net IRD must be determined by calculating the federal estate tax with and without the net IRD. These calculations are based on the federal estate tax, minus the state death tax credit, at the marginal estate tax rate. The estate tax attributable to the net IRD is then apportioned among all IRD beneficiaries. The estate tax attributable to the net IRD equals the difference between the federal estate tax with and without the net IRD and, therefore, the total deduction available to the beneficiaries.
For example, if a 70-year-old participant lives to age 85 and dies in 2015 with a $5 million estate consisting of the $1,541,000 balance in his IRA and $3,459,000 in non-IRD assets, the IRD deduction would be calculated as follows:
|Less deductions in respect of decedent||(0)|
Federal estate tax with net IRD
|Less applicable credit amount||(345,800)|
|Less state death tax credit||(391,600)|
|Federal estate tax with net IRD||$1,653,400|
Federal estate tax without net IRD
|Taxable estate||$ 3,459,000|
|Tentative tax||$ 1,543,250|
|Less applicable credit amount||(345,800)|
|Less state death tax credit||(225,264)|
|Federal estate tax without net IRD||$972,186|
Estate tax attributable to net IRD
|Federal estate tax with net IRD||$1,653,400|
|Less federal estate tax without net IRD||(972,186)|
|Estate tax attributable to net IRD||$681,214|
Using the IRD Deduction
IRD beneficiaries can use the deduction to the extent that IRD is included in their income and must itemize deductions on their personal income tax returns. Although the IRD deduction is not subject to the 2% floor for miscellaneous deductions or the alternative minimum tax, it is subject to the 3% limitation imposed under IRC section 68, in which the itemized deductions are reduced by an amount equal to a taxpayerís adjusted gross income minus a threshold (currently $126,000), multiplied by 3%.
The IRD deduction is available only against the date-of-death value of the IRD assets. Typically, the portion of each distribution that will qualify for the IRD deduction is based upon the following formula:
Estate Tax Attributable to IRD = Estate Tax Value of IRD Asset $681,214 = 44.2% $1,541,000
Using this method, the IRD deduction and taxable IRD income for the first 10 years of distributions to the child in the previous example would be as seen in the Exhibit.
Only 55.8% of the minimum distributions would be taxable. All distributions will be taxed once the IRD deduction is used up. Thus, after the $681,214 estate tax attributed to the IRD assets is deducted, all subsequent distributions will be taxed. An additional $363,241 of IRD deduction remains available after the initial 10-year period. If a distribution in excess of the minimum is taken, the same percentage will apply until such time as the deduction is used up.
By implementing a minimum distribution plan, funding for the inevitable estate tax gifting and life insurance, and taking advantage of the section 691(c) deduction, the most valuable family asset can be preserved without the onerous income and estate tax consequences that result from improper planning. q
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