The Most Overlooked Deduction

Those who inherit IRAs often are not aware of a deduction they can take to shelter IRA distributions from income taxes.

Even most tax experts do not understand “income in respect of a decedent.” Most skip over the topic in school and expect not to run into it. But with so many people owning valuable IRAs, every family that might have a taxable estate needs to know about this issue.

An IRA or other qualified retirement plan is included in the estate of the owner. There is no way to keep the IRA out of the estate. If the estate is taxable, part of the estate tax will be paid on the IRA’s value.

When the beneficiaries take distributions from an inherited IRA, those distributions are included in gross income and taxed at ordinary income rates. Potentially, the IRA is taxed twice. There is the estate tax, and then the income tax.

To partially offset the double tax, beneficiaries are allowed deductions for estate taxes that were paid on the IRA. The tax law calls this income in respect of a decedent. It is available for IRAs, annuities, and some other types of assets.

Here is an example.

Suppose someone left a large estate with an IRA. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA’s share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators available free on the IRS web site, www.irs.gov.