If you own retirement accounts, you should understand how they are taxed at your death. Recognizing potential tax consequences may influence how you proceed with your estate plan, especially if you own substantial assets.
Income in Respect of a Decedent
Not uncommonly, a person might earn money, but not receive it, before he or she dies. This type of income is called "income in respect of a decedent," commonly referred to as IRD. U.S. tax law determines how IRD is taxed in a given situation.
Common examples of IRD include wages or bonuses earned but not yet paid, accrued vacation pay, interest and most retirement accounts.
Retirement accounts like individual retirement accounts (or IRAs) and 401(k)s contain earned income that is not received until later withdrawals are made, so when a retirement-account owner dies and the account passes either directly to a named beneficiary or through the estate, questions arise about taxing that IRD.
Beneficiaries and heirs of most types of retirement accounts are taxed at the time funds are withdrawn at ordinary income tax rates. So if you leave your 401(k) to your son, he will owe income tax on the funds when he removes money from the account.
Alternative tax arrangements may be available for surviving spouses who receive their spouses' retirement accounts.
The Estate Tax
The picture is more complicated if the person bequeathing the retirement account is someone of considerable means whose estate might be subject to the estate tax, a tax on a wealthy estate after the owner dies.
Congress and President Barack Obama agreed to a new estate tax rate for 2011 and 2012. An individual estate is exempt from federal tax up to a value of $5 million ($10 million for that of a married couple). Anything above that level is taxed at a 35 percent rate.
Interaction of IRD and the Estate Tax
With up to $5 million of an estate's value exempt, people who receive retirement accounts (as named beneficiaries or through estate inheritance) from wealthier decedents may wrongly assume that they will not owe taxes on the accounts' income. But the decedents' estate taxes and the beneficiaries' income taxes are two different things.
A deceased individual's retirement accounts are counted as part of his or her taxable estate, so for one worth over $5 million the value of a retirement account increases the estate tax. Some wealthy retirement-account holders who are concerned about this are considering alternatives like leaving the accounts to charity or converting them to Roth IRAs.
When a retirement account passes in an estate subject to estate tax, the recipient still owes income tax when he or she withdraws money. The account value is still taxed as part of the estate. To offset this double taxation, the new account owner can take a tax deduction corresponding roughly to that part of the estate tax attributable to that account's value.
This deduction is often overlooked by tax accountants, and can be a windfall to the new account owner if he or she is not also an heir of the estate that was taxed on the account value.
Get Legal Guidance
This is only a preliminary look at the tax issues that arise when retirement accounts are inherited. Whether you are contemplating how you will bequeath your retirement accounts, or are receiving such an account under these circumstances, the advice of an experienced estate planning attorney who also has a firm understanding of tax matters is imperative.
