As you know, IRAs and other retirement plans are included in the estate of the owner…
And subject to federal estate taxes — when the estate is valuable enough.
Here’s what many people don’t know:
Unlike other assets, the tax basis of IRAs is not increased to current fair market value by those who inherit them.
The beneficiaries who inherit an IRA or retirement plan account must include distributions in their income, just as the owners would have.
This means that the retirement plan was subject to estate taxes when included in the original owner’s gross estate…
AND taxed again when distributions are included in the gross income of the beneficiaries.
That’s what we refer to as the dreaded “double tax.”
Fortunately, there are two ways to reduce or eliminate this double tax.
First, the heirs should realize that they get a deduction against their income tax for any estate taxes paid that were attributable to the retirement plans.
This is a fairly complicated section of the tax code known as “income in respect of a decedent.”
Few financial professionals are acquainted with this. So let me break this down in plain English…
Pension plans pay income in respect of a decedent, and IRA beneficiaries qualify for a deduction to the extent that the estate paid taxes on the retirement assets.
But the deduction is not all it appears at first.
The deduction is an itemized deduction for miscellaneous expenses.
That means you can take the deduction only if you itemize expenses on Schedule A.
It also means you deduct only that portion of the expense which, when coupled with your other miscellaneous itemized expenses, exceeds 2% of adjusted gross income.
Finally, the deduction can only be taken in years when income is received from the IRA, and most tax professionals believe it can be taken only up to the amount of the income for the year.
Unused deductions can be carried forward to future years.
Now here’s the second way you can reduce or get rid of a “double tax…”
IRA beneficiaries can disclaim any interest they might be entitled to in the retirement plans.
This makes sense when there is a surviving spouse who is listed as a beneficiary or contingent beneficiary for the account, along with the children.
If the children disclaim their interests in the IRA, then the retirement plan would pass to the surviving spouse and would avoid estate taxes because of the marital deduction.
That would leave only one level of tax, the income tax, when the spouse takes distributions.
Any assets that remain when the spouse dies might be subject to the estate tax again at that time.
The children would include in gross income any distributions they receive from the IRA after inheriting it from the second spouse.
But in the interim, everyone would have been able to plan for ways to develop the surviving spouse’s plan to minimize taxes on the IRA.