AnnuityAdvisors - Where advisors go for advice
By Margaret A. Kruse
Product Tax Counsel
Integrity Life Insurance Company
(888) 644-2300 ext. 7945

Annuities, IRAs and qualified plans are tax deferred.

When the owner dies, the income tax liability is passed on to the beneficiaries of the annuity or IRA. The beneficiaries must pay income tax as they receive the payments.

An account held by a beneficiary after the owner dies may be composed of: This income which accrued before the owner's death that is now taxed to the beneficiaries is called Income in Respect of a Decedent (IRD).

At the owner's death, the entire value of the basis and earnings during the owner's life is included in the taxable estate. The benes therefore bear the burden of: The beneficiary may be eligible for a special income tax deduction when he takes a distribution and reports the IRD. The deduction helps offset any estate taxes which were due on the IRD when the owner died. This reduces the double-tax.

Example: Suppose Mother dies owning a $500,000 IRA, composed entirely of deductible contributions and earnings (and it's her only IRD). Her total taxable estate is $4,000,000. This $500,000 IRA is included in her taxable estate and subject to estate tax. Then, as the IRA payments are distributed to Son (the beneficiary) over time, Son must include the distribution in his taxable income. So Son bears the burden of two taxes on this income - the estate tax followed by the income tax. Son is estate taxed on the income tax liability.

In order to provide some relief from this double-tax on IRD, Son is allowed to take an income tax deduction for the estate tax attributable to the IRD. He reports this deduction on his 1040 in years he takes distributions from the IRA. The deduction can significantly reduce his income tax on the IRA distributions.

The beneficiary uses a 2-step process to figure out the IRD deduction for his 1040. First, he figures out what the total deduction is by calculating the estate tax the deceased had to pay on the IRD. Second, he figures out what chunk of this deduction he can use in any year that he takes a distribution from the IRD account.

Step 1. First, you figure out how much estate tax was paid on the IRD. This gives you the deduction amount. In figuring how much estate taxes were paid, you assume (favorably) that the IRD was estate taxed at the margin. To do this, you calculate the estate tax with the IRD included in the estate, then calculate the estate tax without the IRD included in the estate. The difference is the amount of estate tax attributable to the IRD. (For simplicity, we're assuming an estate tax rate of 50%, when in reality the estate tax rate would be 49%.)

Calculate the IRD deduction

        Estate tax on a $4,000,000 estate (including the $500,000 of IRD) is $1,775,800.

        Estate tax on $3,500,000 (all of estate except the $500,000 of IRD) is $1,525,800.

         $1,775,800 - $1,525,800 =$250,000.

        Therefore $250,000 of Mother's $1,775,800 estate tax is attributable to the IRD.

You only do this step once-now that you have the deduction amount, it's a question of figuring out how much you can use each year.

Step 2: Once this deduction is figured, it is doled out in years that you take distributions and have to pay the income taxes on the IRD.

To figure this out using our example, you calculate what percent of Mom's IRD items are included in Son's income for that year. This tells you what fraction of the deduction he can take for the year.

Suppose in our example Son took a lump sum of the entire IRA for the tax year. His ratio would be:

        $500,000 IRD items included in income for the year
        = 100% X $250,000 deduction
        $500,000 total IRD items in Mother's estate

So 100% of the $250,000 deduction would be allowed for the year. This $250,000 deduction would offset a large portion of the $500,000 added to Son's income for the year. Similarly, if he included half or a quarter of the IRD in income, he would get to use half or a quarter of the $250,000 deduction.

The point: the beneficiary's income tax on the IRA distribution may not be as high as you think if the owner had to pay estate tax on the IRA. The client should ask his attorney or accountant for help in figuring the IRD deduction.

The income tax deduction is figured only for estate taxes actually paid on the IRA. If some of the IRA or annuity went to a spouse beneficiary under the marital deduction, that amount was not subject to the estate tax because of the martial deduction. Since no estate tax was paid, the spouse would not get an offsetting income tax deduction. Similarly, there will not be an IRD deduction if the owner's taxable estate less than $1,000,000 (in 2003), because no estate taxes will be due. The Applicable Credit Amount (fka the unified credit) offsets the tax.

Some miscellaneous points: Notice how IRD assets differ from capital gain assets. At death, the basis of a capital asset is stepped up to fair market value, so the heirs do not have to pay any income tax on the gain which accrued during the owner's life. IRD assets, though, do not get a basis step-up. The income tax obligation remains intact and passes on to the beneficiaries. Some people want to spend IRD assets for their lifetime needs rather than capital gain assets, to preserve the benefit of the basis step up on the capital gains assets. Your client's tax advisors should help the client to decide which assets to use to pay retirement expenses.

Generally, Roth IRA's should not have an IRD problem because most after-death distributions will not be income taxable to beneficiaries. (It is possible, though, in the case of a distribution within five years of the Roth account's creation.)

Other IRD assets include accrued but unpaid compensation, commissions, interest, dividends and installment sales. There are also "deductions in respect of a decedent," (DRD) which offset IRD. The income tax deduction is for the estate taxes attributable to net IRD (IRD minus DRD).

Last Updated: 2/25/2004 1:29:00 AM