Income in respect of a decedent (“IRD”) is taxable income to which a decedent was entitled before his or her death, but which was not actually paid before death. IRD applies to assets where the income is deferred rather than paid out immediately, assets such as IRAs, annuities, and government savings bonds. IRD is taxed to the recipient, and for that reason is referred to as “in respect of” the decedent.
The tax effects of IRD can be onerous. Consider the following example: The decedent has an estate of $5,000,000, including a $100,000 IRA. The estate tax allocable to the IRA is $45,000. The beneficiary of the IRA, who is in a 35% income tax bracket, would pay $35,000 in income taxes when he or she withdraws the funds from the IRA. The total tax liability on the $100,000 IRA is $80,000!
There are a few strategies to help alleviate the effect of IRD rules. First, a decedent should plan his estate so that there is no federal estate tax, or to reduce the amount of potential IRD by lifetime drawdowns of the IRD asset.
Secondly, when the asset generating the IRD is an IRA, the IRA owner should consider exchanging the IRA for a lifetime annuity and using some portion of the annual annuity payment to fund an irrevocable life insurance trust for beneficiaries who will receive their bequest both IRD and estate tax free. Alternatively, the IRA owner could use some portion of the required annual IRA distribution to fund the trust. An IRA beneficiary can also disclaim the IRA in whole or in part in favor of successor beneficiaries in a lower income tax bracket.
Finally, an IRD beneficiary should remember to take the income tax deduction in the amount of the estate tax paid. In the above example, the $100,000 of IRD income would be reduced by $45,000 (the amount of the estate tax paid), such that the income is $55,000, and the tax thereon (at 35%) would be $19,250. When added to the estate tax paid, the total tax is $64,250, still a substantial amount of tax.
Potential IRD situations require careful consideration and planning. If you need to review IRD issues or your estate plan in general, please do not hesitate to telephone us.