Life and Death Planning for Retirement Benefits

Chapter 4: Inherited Benefits: Advising Executors and Beneficiaries

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Harvey and Emma Example: Harvey dies in 2009, leaving his $5 million taxable estate (including a $1 million pension plan) to his daughter Emma. The federal estate tax in 2009 on a $5 million taxable estate was $675,000. If the $1 million IRA were excluded from the taxable estate, the taxable estate would be only $4 million, and the federal estate tax would be $225,000. Thus the amount of federal estate tax attributable to the IRA is $675,000 - $225,000, or $450,000. Emma will be entitled to an income tax deduction of $450,000 which she can claim when she receives the $1 million pension distribution. 1. The deductible portion of the estate tax is computed at the marginal rate, not the average rate; this is favorable to the beneficiary. In the Harvey and Emma Example, even though the IRA constituted only 20 percent of the taxable estate, it accounted for 67 percent of the estate tax, so the IRD deduction equals 67 percent of the total estate tax. 2. The federal estate tax is repealed for deaths in 2010, then reinstated (under EGTRRA’s sunset provision, § 901) for deaths in 2011 and later. See ¶ 4.3.08 . EGTRRA did not repeal or amend § 691 , so if federal estate taxes are paid (because the participant died in a year in which the estate tax was in effect), they can be deducted when the beneficiary receives a distribution from the plan, even if the distribution occurs in 2010. 3. The estate tax does not have to be paid before the deduction can be taken, as long as it is owed and attributable to the IRD. PLR 2000-11023. 4. There is a limited deduction for generation-skipping transfer (GST) taxes; see § 691(c)(3) . Computation of the § 691(c) deduction becomes more complex if a marital, charitable, or state death tax deduction is involved; see Reg. § 1.691(c)-1(a)(2) . These topics are beyond the scope of this book. See instead, the highly-recommended Estate Planner’s Guide to Income in Respect of a Decedent by Alan S. Acker ( Bibliography ). The IRD deduction can create an incentive to cash out retirement benefits soon after the participant’s death if the IRD is a relatively small part of a large estate. If the estate is large, the marginal estate tax bracket will be high, and that will make a relatively larger share of the IRD tax-free upon distribution. The beneficiary who receives the retirement plan distribution will therefore not lose too much of the distribution to income taxes, and can reinvest the after -tax distribution in property that will produce long-term capital gains and/or dividends, both of which (currently) enjoy relatively low income tax rates. In contrast, if the estate is not so large (so the estate tax and the resulting § 691(c) deduction are low), and/or if the retirement plan is a large portion of the estate (if it is large enough, the “tax attributable” to the IRD tends to be closer to the average rate of tax on the estate than to the highest marginal bracket applicable to the estate), there is less incentive for beneficiaries to take early distributions. Note that:

Who gets the § 691(c) (IRD) deduction

The § 691(c) deduction goes to the person who receives the IRD, regardless of who paid the estate tax. JackExample: Jack dies in 2002 with an estate of $3 million. He leaves his $1 million IRA (which is entirely IRD) to his daughter Jill. He leaves his $2 million probate estate (which is not IRD) to