Caution: This Estate Includes IRD

Caution: This Estate Includes IRD, here\’s a fictional story you may find interesting if you\’re planning your estate.

Ted’s Tale

Ted was a successful executive. He had a large estate when he died, all of which he left to his two children, Tina and Tom.

Under Ted’s estate plan, Tina will receive land valued at $1 million. Tom is the beneficiary of Ted’s 401(k) account, also worth $1 million. The children will divide the remainder of Ted’s estate equally, as his will directs.

Fair enough, or so it seemed until Tom received a communication from the 401(k) plan outlining his distribution options. The problem? Tom has learned he’ll have to payincome tax on the money he receives from the plan. He can defer the tax by rolling the money into an individual retirement account (IRA), but withdrawals from the IRA will be taxable to him at his ordinary tax rate. And he can’t leave all his money in the rollover IRA indefinitely — under tax law rules, he’ll have to withdraw at least a minimum amount annually.

With federal income-tax rates now as high as 35% — and even higher rates scheduled to take effect in 2013 — income tax will take a significant bite from Tom’s inherited plan assets. Meanwhile, Tina won’t owe any income tax on the land she receives. So much for 50-50!

Why are the inherited 401(k) benefits subject to income tax while the land is not?

The Culprit: IRD

Retirement plan benefits have the dubious distinction of being considered “income in respect of a decedent” (IRD) under the tax law. Essentially, IRD is income a person earned and was entitled to receive but did not actually receive before death. IRD is not reported on a decedent’s final income-tax return. Instead, IRD is generally taxed to the recipient.

Qualified retirement plans and traditional IRAs are common sources of IRD. Other examples include:

• A decedent’s final paycheck for wages earned but not paid until after death
• Bonuses and sales commissions earned but not paid until after death
• Deferred compensation
• Uncollected payments on an installment note
• Accrued interest

An IRD recipient may be entitled to an income-tax deduction for any federal estate tax attributable to inclusion of the right to receive the IRD in the decedent’s gross estate.

A Potential Trap

Generally, if property has appreciated, its fair market value at the time of death becomes the new owner’s cost basis for tax purposes. For example, Tina’s basis in the property she inherited is $1 million. If she decides to sell the land, she’ll be taxed only on any gain over and above the property’s $1 million date-of-death value (her tax basis).

IRD doesn’t receive the same basis step-up. Sometimes, taxpayers inadvertently create an IRD situation — and their heirs pay the tax price. For example, Ted could have created an IRD issue for Tina if he’d sold the land on the installment basis just before he died. With an installment sale, capital gain is generally recognized over time as payments are received from the buyer. As beneficiary of the installment note, Tina would have been required to pay the related capital gains tax as she collected payments on the note.

As Ted’s tale illustrates, IRD is a tax issue that shouldn’t be overlooked when planning an estate.

SEPTEMBER

17 Individuals: Third installment of 2012 estimated tax due; file Form 1040-ES.

17 Corporations: Last day for filing 2011 income-tax return (Form 1120, 1120S) by a calendar-year corporation that obtained an automatic six-month filing extension.

17 Corporations: Due date for depositing the third installment of estimated income tax for 2012.

17 Partnerships: Last day for filing 2011 return (Form 1065) by a calendar-year partnership that obtained a five-month filing extension.

OCTOBER

15 Individuals: File 2011 federal income-tax return and pay any tax due if you obtained a six-month filing extension.

31 Employers: File Form 941, Employer’s Quarterly Federal Tax Return, for the third quarter of 2012.

NOVEMBER

12 Employers: Deferred due date for Form 941, if timely deposits were made.