Hidden Tax Opportunity For Tax-Deferred Investments

As IRA and other retirement plan account balances continue to grow larger, often into very significant amounts, the need to understand tax characteristics becomes more critical.

These types of accounts offer the tremendous benefit of tax deferral, as everyone is well aware, but a “taxing” problem may remain upon the death of the participant. This quandary is known as income in respect of a decedent. Income in respect of a decedent is income to which the decedent was entitled, but due to his or her death was not includable in his or her taxable income. In other words, IRD assets do not receive a step-up in cost basis at death like capital assets. Therefore, they are taxable to the estate or the heir who receives them.

Another unique characteristic of IRD assets is potential dual taxation. They are included in the gross estate of the decedent, so they are subject to estate taxes. Further, the IRD asset, when distributed, is subject to income tax upon receipt. If a beneficiary receives the IRD, it is included in his or her ordinary income for that tax year and he or she is taxed on it. However, there is a hidden tax opportunity just waiting to be utilized: a 691(c) deduction.

691(c ) is an income tax deduction designed to offset the double whammy on inherited assets that incur both federal estate and income taxes.

But income tax forms don’t flag this important tax break, popular tax-preparation software barely mentions it, and many accountants and attorneys are unaware of its importance. This deduction is likely to be most useful for people who have inherited IRAs or other such retirement plans. But the deduction also applies to things such as lottery winnings and interest on unredeemed U.S. savings bonds.

A growing number of individuals who qualify for this deduction are throwing it away every year because they have no idea it even exists.

To determine if the deduction can be claimed, it is necessary to examine the decedent’s federal estate tax return. If there is no federal estate tax, then the income tax deduction is not allowed because double taxation has not occurred. But if there is a federal estate tax, an income tax deduction is permitted based upon the estate tax directly attributable to the net value of the IRD.

The deduction can be claimed as distributions from the IRD asset becomes subject to income tax. Therefore, it is important for beneficiaries to keep track of how much of the deduction they have used.

To claim the deduction, individuals must itemize. Unlike other miscellaneous itemized deductions, which can be written off only to the extent they exceed 2% of an individual’s adjusted gross income, the deduction for income in respect of a decedent can be claimed in full. Individuals who missed the IRD deduction when they first inherited the asset may have an opportunity to amend their returns.

Of course, this brief article is no substitute for a careful review of your unique personal circumstances. Before implementing any significant income tax strategy, please contact a tax professional and Financial Advisor.