Jumbo IRAs, large 401Ks, and other qualified pension money are subject to a double tax up to 80% if the owner of the large IRA dies with an estate tax problem.
IRD: “Income in Respect of a Decedent” Internal Revenue Code Sec. 691(c) refers to those amounts to which a decedent was entitled to receive as gross income, but which were not properly includable in computing the decedent’s taxable income for the taxable year ending with the date of the decedent’s death or for a previous taxable year under the method of accounting employed by the decedent.
Rev. Rul. 92-47 holds that a distribution to the beneficiary of a decedent’s IRA is IRD (“Income in Respect of a Decedent”) under Sec. 691. The amount of the IRA distribution is included in the gross income of the beneficiary for the tax year when it is received. However, Sec. 642(c)(2) provides that an estate or a trust shall be allowed a deduction for any amount that is permanently set aside for charitable purposes.
Reg. 1.691(a)-1(b). IRD assets are those in which there is either untaxed ordinary income or a deferral of capital gain. When the beneficiary receives the asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation if he or she had recognized the income or gain.
A decedent’s gross estate includes the value at the time of decedent’s death of “all property, real or personal, tangible or intangible, wherever situated.” See IRS Code Sec. 2031(a). A decedent’s estate may include stocks and securities, real estate, business interests, personal effects, annuities, trusts, 401Ks, IRAs, and other qualified plans. Each of these items is subject to a valuation determination as set forth in IRS Reg.20.2031-1.
When IRA is Subject to Double Taxation
If you are over the age of 60+ and you have assets subject to an estate tax, your IRA is guaranteed to be subject to a double taxation (75% or more) under IRS Code Sec. 961(c).
Example: If you have a $5million estate and a $1million IRA (Jumbo IRA / Large IRA), because of IRD “Income in Respect of a Decedent” your heirs will only get $250,000. The government has written itself in for a guaranteed $750,000 because you voluntarily did not mitigate this double-tax penalty.
Large IRA (Jumbo IRA) = $1,000,000
Estate Tax*: ($500,000)
Income Taxes (state** and federal*): ($250,000)
Total Taxes on Large IRA*: ($750,000) 75%
Total IRA distributed to your loved ones, the beneficiaries: $250,000 25%
* For illustration purposes only. Japan has a higher rate of 70%, Germany takes a maximum of 40%, while Australia and Canada, take nothing.
** Taxes on inherited wealth are a traditional and common revenue source for states. Some 16 states collect approximately $4.5 billion per year from these taxes. Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Oregon, Rhode Island, Vermont, the District of Columbia, Connecticut, Kansas, Oklahoma, and Washington. The estate tax in Wisconsin expired effective July 2007 and in Kansas and Oklahoma will expire effective 2010.
Simply stated, IRD is income a decedent earned and was entitled to receive but never actually received before his or her death. An example would be a paycheck for wages not paid until after death. The paycheck would be included in his estate for estate tax purposes and is taxed to whoever received the check.
IRAs, 401Ks, and other qualified retirement plans are considered to be IRD property when received by a beneficiary. Other IRD assets are: Unpaid bonuses, unpaid interest, dividends, fees, commissions, installment notes, rents, sale proceeds on sales before death.
Tax Planning IRA
Tax planning for large IRAs, Jumbo IRAs, 401Ks, and other qualified large pension assets can pose a number of complex problems, resulting mostly from the interplay of several distinct set of tax rules. On the death of the IRA owner, the IRA and other qualified plans, face a potential double tax hit. First, the fair cash value of the asset is includable in the taxable estate for estate tax purposes up to 55% plus applicable state taxes on the same amount (State estate taxes and federal estate taxes are two separate taxes). Second, payments from the IRA to other beneficiaries are subject to the income tax, based on the theory that no income taxes were paid during the life of the original IRA owner.
Further complicating large IRA planning is made more difficult by the some time complex rules on mandatory “Required Minimum Distributions” (RMDs) applicable to IRAs imposing a 50% penalty tax on amounts that should have been distributed.
Required Minimum Distributions (RMDs) generally are minimum amounts that the IRA owner must withdraw annually, starting with the year that he or she reaches 70 1/2 years of age or, if later, the year in which he or she retires.
IRA Rescue Planning
IRA rescue planning is a term used to take positive action to eliminate the estate tax and to mitigate the income tax consequences of a double tax on large IRAs, 401Ks, and other qualified pension plans. Because of the devastating tax consequences, the first objective is to create a scenario to pass more wealth to heirs.
Stretch IRA Beneficiary – Avoiding Income Taxes on IRA
One solution that works, if you do NOT have an estate tax problem, is the Stretch IRA. As the name implies “stretch” the designated beneficiary is someone other than the owner, such as your child or grandchild. Distributions are “stretched” over the life expectancy of the child (instead of the IRA owner). Essentially this is to avoid the “lump-sum” payment of income taxes on the IRA, by stretching distributions over the life of the child or grandchild.
As stated, IRA rescue is much more important if you have an estate tax problem. Stretch IRAs do NOT work for those that have an estate tax problem. If you pass an IRA to a child/beneficiary through a Stretch IRA, your estate will have to deal with the 55% estate tax, which is due when passing that asset to their heirs. Where is the child going to get funds to pay the 55% tax? Why the IRA of course. The problem is that the beneficiary will have to pay income taxes upon taking the money out of the IRA to pay the estate taxes; and if the beneficiary is under the age of 59 1/2, a 10% penalty will be levied upon the withdrawal from the IRA. It’s a vicious cycle.