Most tax preparers likely have heard of an IRD deduction. But since it’s less frequently claimed than many other types of deductions, many practitioners still have some questions about when and how it is used.
With tax season once again upon us, now is a good time for a refresher on this important tool. Consider this scenario: Your client mentions that he has inherited a significant retirement planning asset (an IRA or a 401(k)) from his father. Those assets are known as IRD (or income in respect of decedent) assets, because they include a right to income that was owed to the decedent when he died.
One drawback to IRD assets is that they can come with a hefty tax penalty. Unlike most other inherited assets, which the beneficiary receives income-tax-free, IRD assets require the beneficiary to pay income taxes. And this is after up to 40% of the tax-deferred asset may have been lost to federal estate taxes.
However, to mitigate any double taxation (estate tax and income tax), beneficiaries may be entitled to take an income tax deduction for the estate and generation-skipping transfer tax attributable to the IRD on their individual income tax returns for the year they include the IRD in income. (Note that the IRD deduction also applies to inherited nonqualified stock options, dividends declared but not paid at death, and pretax gains in nonqualified annuities.)
This deduction can be easily overlooked, as frequently the CPA who prepares the beneficiary’s personal income tax return is not the same person who prepares the decedent’s federal estate tax return. If there is no communication or coordination between the professionals who prepare these documents, the beneficiary may not realize he can take advantage of the deduction.
The IRD deduction is a miscellaneous itemized tax deduction, not subject to the 2% of AGI floor (although it is subject to the Pease limitation; see below). Unlike miscellaneous itemized deductions subject to the 2% floor, the beneficiary can claim the IRD deduction even if he or she is subject to the alternative minimum tax.
If your client did not claim the IRD deduction but has already received IRD assets, it may not be too late for the client to take advantage of the deduction by filing amended income tax returns for the past three years in any year in which he or she withdrew funds from the tax-deferred asset. If the client has not withdrawn all the funds from the tax-deferred asset, the deduction is still available for subsequent withdrawals. The IRD deduction can be claimed as funds are withdrawn; however, the IRD deduction must be proportional to the withdrawal. In other words, if the client withdraws 15% of the IRD asset, he or she can claim 15% of the IRD deduction.
Limitations to the IRD deduction
The IRD deduction is subject to certain conditions. For instance: Under the revised Pease limitation, if a taxpayer has AGI in 2016 that exceeds $259,400 if single (or $311,300 if married filing jointly), itemized deductions including the IRD deduction are reduced by 3% of the taxpayer’s AGI above the threshold. (The Pease limitation also mandates that no more than 80% of the itemized deductions can be taken away.)
Another important caveat: The IRD deduction applies only to federal estate taxes paid, not to state estate or inheritance taxes, so the decedent’s estate must have incurred a federal estate tax for beneficiaries to use the deduction. If the decedent does not have a federal taxable estate, but inheritances are taxable under state law, beneficiaries will incur a double tax, as the tax-deferred asset is taxable to the beneficiary (or included in the decedent’s taxable estate for state estate tax purposes) and the beneficiary is not entitled to a federal IRD deduction or to a state IRD income tax deduction.
There is a way your clients can help prevent their beneficiaries from owing this double tax if the IRD asset is a traditional IRA or employer-sponsored retirement plan (e.g., a 401(k)) account. If the taxpayer has such an account and knows that he or she will have a state-estate-taxable estate (but not a federal one), the taxpayer may consider converting the IRA or plan account to a Roth IRA. This strategy allows the plan holder to prepay income tax, reducing his or her taxable estate. Plus, any appreciation post-Roth-conversion avoids the double tax because, for the most part, any withdrawal from an inherited Roth IRA is tax-free.
The IRD deduction highlights the need for clients with substantial tax-deferred assets to have a strong advisory team. Frequently, the tax-deferred asset is the most significant asset these clients own. The CPA can help clients protect this asset by coordinating with other estate planning team members, such as an estate planning attorney, to ensure that all tax savings opportunities are explored and aligned.
For more information on planning strategies like the one outlined in this article, refer to The CPA’s Guide to Financial and Estate Planning. AICPA PFP/PFS members have free access to this comprehensive, four-volume guide, which is updated annually and provides guidance to CPAs advising clients in tax, estate, retirement, investment, and risk management matters, including succession planning for closely held businesses. Nonmembers can download free excerpts of the guide and purchase the guide.