Life and Death Planning for Retirement Benefits

Chapter 4: Inherited Benefits: Advising Executors and Beneficiaries

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Generally, the same income tax rules apply to beneficiaries as applied during the participant’s life: Benefits are taxable only when they are actually distributed ( ¶ 2.1.01 ), distributions are taxable as ordinary income unless one of the exceptions listed at ¶ 2.1.06 applies, etc. However, additional considerations arise:  Rollovers: The ability to use a rollover (¶ 2.6) to avoid income tax on a distribution is curtailed or in some cases eliminated, unless the beneficiary is the participant’s surviving spouse; see ¶ 4.2 and ¶ 3.2 regarding beneficiary rollovers.  IRD deduction: The beneficiary is entitled to an income tax deduction for federal estate taxes paid on the inherited benefits. See ¶ 4.6.04 – ¶ 4.6.08 .  Kiddy tax: The “kiddy tax” may apply: Under § 1(g), a child who is under age 24 may be taxable on his “unearned income” at his parents’ income tax rate. Income resulting from a distribution from an inherited retirement plan is considered “unearned income” for this purpose. Reg. § 1.1(i)-1T , A-6, A-9.  No more $5,000 death benefit exclusion. For beneficiaries of participants who died prior to August 21, 1996, up to $5,000 of employee death benefits could be excluded from the beneficiary’s income. This “$5,000 death benefit exclusion” no longer exists. See former § 101(b), repealed by the Small Business Job Protection Act of 1996. Income in respect of a decedent (IRD) is not defined in the Code. The IRS defines it as “amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year ....” Reg. § 1.691(a)-1(b) . Death benefits under qualified plans, 403(b) plans, and IRAs are IRD. Rev. Rul. 92-47, 1992-1 CB 198; Reg. § 1.663(c)-5 , Example 9; PLR 9341008. IRD does not qualify for any “basis step-up” at the decedent’s death; see ¶ 4.3.08 . Normally, IRD is includible (when received) in the gross income of the person or entity who acquired, from the decedent, the right to receive such income. § 691(a)(1) . Colin Example: Colin’s estate is named as beneficiary of Colin’s IRA, which is entirely pretax money. The estate withdraws money from the IRA. The withdrawal is includible in the estate’s gross income as IRD. § 691(a)(1)(A) . Barbara Example: The beneficiary designation for Barbara’s 403(b) account (which is entirely pretax money) provides that the first $20,000 of the account shall be distributed to Lucy, and the balance shall be paid to Tom. Upon Barbara’s demise, Lucy withdraws her $20,000; that distribution is includible in her gross income as IRD. Whenever Tom withdraws from the account, such withdrawals will be includible in his gross income as IRD. § 691(a)(1)(B) . Definition of IRD; why it is taxable When IRD is taxed (normally when received)

Tax on transfer of the right-to-receive IRD

Although much less common than distributions, there is another event that can cause IRD to be taxable. If the person or entity who inherited the right-to-receive the IRD from the decedent transfers that right-to-receive-IRD to someone else, § 691(a)(2) provides that the IRD is immediately taxable, to the transferor. A distribution from a retirement plan is IRD; the retirement