11/07/2000

A Tax That Affects Your Estate

In this article, I will address an issue that most people never even think of and I doubt have heard much about. When it comes to issues of estate planning, most everyone focuses on the transfer document -- the will or trust -- and the concern over possible estate taxes. Obviously, these are key issues. However, there is one issue that is often overlooked and it affects small and large estates alike. It is -- Income in Respect of a Decedent or IRD.

IRD Defined

What is IRD? Simply put, IRD is income generated from an inherited asset that you, as the inheriting party must pay income taxes on. Do all assets generate IRD? No, most assets do not generate IRD. The following is a list of assets that may be inherited without an income tax liability: banks accounts, certificate of deposit, stock, bonds, mutual funds, real estate, and business assets. Proceeds from a life insurance policy on the deceased that is paybale directly to the heir(s) is generally exempt from income tax.

The assets listed above do not generate IRD because they generally receive a step-up in basis. A step-up in basis means that upon the death of the owner, the original cost basis of the assets "steps-up" to the current fair market value. For example, assume your father purchased a stock for $10/share. Upon his death the same stock was worth $120/share.

At that time, you as the new owner in the stock receive a step-up in basis -- you own the stock at the fair market value of $120/share not $10/share. If you sell the stock immediately, you will not have to pay any capital gains.

Assets Subject to IRD

Alternately, there are assets that do not receive a step-up in basis and may generate income in respect of a decedent. They are:

• Deferred Annuities: The beneficiary will have the same cost basis as the account owner. Therefore, if contributions to the annuity total $25,000 and the annuity is valued at $40,000, the beneficiary will owe income taxes on the $15,000 over the basis when the proceeds are payable.

  Example: Many elderly people purchase annuities, but are largely unaware of the tax consequences for the heirs. The father of one of my clients recently passed away. Several years early his father had purchased an annuity. My client, as the beneficiary, is now left paying income taxes on the growth in the annuity. If his father had simply keep that investment in mutual funds for example, the full amount would receive a step-up in basis and my client would not have had to pay any income taxes.

• Immediate Annuities still with period certain: Depending on the settlement option available, generally the proceeds payable to a beneficiary under period certain option are received as taxable income. An immediate annuity pays an immediate income stream to the owner. Often that income streams is "guaranteed" for a certain period of years -- e.g. 20 years. If the annuitant dies in year 7, the remaining payments are guaranteed to continue to the beneficiary for the next 13 years. The income payments will likely create IRD and be subject to income tax.

• Employer Sponsored Qualified Retirement accounts (401k, TSA, Company Pension Plans): How assets can be distributed from such plans are defined by the specific plan document. However, amounts the cannot be rolled over (perhaps to a non-spouse beneficiary) and must be withdrawn or payments the are directly received (say from a pension plan) by the heir is IRD to the heir.

• IRA's and Rollover IRA's: Amounts withdrawn are fully included as income to the heir, except for withdrawals that are attributed to non-deductible IRA contributions.

• EE Bonds: Deferred interest payable when the bonds are surrendered or reissued is taxed as income to the beneficiary receiving the proceeds or the new owner of the bonds.

• Other: Salary, bonus, commissions, rents, or any income which would have been taxable as income to the deceased owner, becomes taxable to the heir who receives it as "income in respect of decedent".

How Big a Problem can IRD BE?

Let's consider three kinds of accounts that might be inherited and consider the impact on the net inheritance. For simplicity, I will assume that the heir has a total gross income of only $30,000, and files as a single taxpayer. After the standard deduction and personal exemption, the heir would be in the 15% marginal tax bracket.

 

	Mutual Fund	Deferred Annuity	IRA Account
Account Value	$100,000	$100,000	$100,000
Cost Basis	$50,000	$50,000	0
Subject to IRD	0	$50,000	$100,000
Additional Taxes Due	0	$13,829	$29,329
Net Inheritance	$100,000	$86,171	$70,671

* Excludes State Income and Inheritance Taxes

In Summary

The above chart shows the possible depletion of assets for a person with a modest income. For many middle-income and moderately affluent families, the taxes due on "Income in Respect of a Decedent" cause more significant erosion of inheritances than do estate taxes. Therefore, one must carefully plan for the transfer of the estate, especially with assets that may generate IRD. Careful planning could mean that your heirs enjoy more of the fruits of your labor.

Please send questions or comments to dcoffin46333@wradvisors.com.