An antidote for the IRS headache of inheriting IRA and 401(k) funds

Associated Press

NEW YORK — Americans have long been encouraged to save for retirement, and many have accumulated sizable Individual Retirement Accounts and company-sponsored 401(k) plan accounts.

Some of that wealth is now being passed on to the next generation, and beneficiaries must deal with paying taxes under a little-known Internal Revenue Service provision with the cumbersome name of "income in respect of a decedent."

"Retirement savings accounts have ballooned," said Randi Schuster, an estate tax specialist with the accounting firm BDO Seidman in New York. "In many cases, retirement accounts are someone’s sole savings or the largest part of their savings. So more attention is being paid to the estate implications — and to planning for them."

Income in respect of a decedent is income a person earned but had not yet paid taxes on at the time of his or her death. Inheritors — individuals, estate or trusts — must pay income tax on those assets.

Take the case of IRAs. These accounts are funded with pretax income and grow over the years tax-deferred. Or they can be rollover IRAs, used to hold a person’s pension payout.

As retirees draw money from IRAs, they pay federal and state income tax on the withdrawals. If they die, whoever inherits the accounts must pay taxes on withdrawals, too.

IRAs and 401(k) accounts aren’t the only assets subject to taxes. Income taxes also must be paid by heirs on most qualified pension and profit-sharing plans, on savings bond interest and on some stock options and annuities.

"A lot of people don’t realize how much they’ve accumulated," Schuster said. "Add up the pensions, the savings, the house, and before you know it you could have more than $1 million. If it’s not structured properly, heirs could end up owning a lot of taxes — estate taxes and income taxes."

Bill Massey of RIA, a New York publisher of tax information for accountants and tax professionals, points out that most people who inherit the proceeds from retirement accounts can spread withdrawals out over a number of years, thus reducing the annual tax bite.

A woman who inherits her husband’s IRA can, for example, elect to treat it as her own and defer distributions until she reaches 70 1/2. If children are the beneficiaries, they can take minimum annual distributions, depending on their age. (IRS tables dealing with distributions can be found in Publication 590 at www.irs.gov).

"People with small estates can take some simple steps to minimize the tax bite," Massey said.

Elderly retirees could accelerate their withdrawals from IRAs, pay the taxes at a presumably low income tax rate, and give the money as a gift to children. Up to $11,000 can be given tax-free to each child under the annual gift exclusion, Massey pointed out.

Another option is bequeathing an IRA to a charitable organization, which would be exempt from taxes, and leaving other assets to heirs.

BDO Seidman’s Schuster said couples with larger estates can minimize the tax bite with a variety of estate-planning tools including charitable and life insurance trusts.

In the case of large estates — those over $1 million — IRAs can be subject to double taxation: estate taxes and income taxes. But there’s a little-known income tax deduction that heirs can use to offset some of the estate taxes, said New York accountant Ed Slott, who publishes Ed Slott’s IRA Advisor newsletter.

"Most consumers and taxpayers don’t know about it (the deduction)," he said. "But it’s going to become a bigger and bigger issue and people with those big IRAs start dying off."

IRS Publication 559 explains how to claim the deduction.

Slott said beneficiaries who overlooked the IRD deduction can go back and amend the last three years of their federal and state returns to get refunds.