Inherited IRAs can come with a large tax burden – so large that the value of the IRA may be almost entirely diminished between estate taxes and income taxes. However, there is a little-known deduction that can significantly lower a beneficiary’s tax burden in regards to any income in respect of a decedent. Read more to learn about how you can save a large amount of tax on an inherited IRA with a relatively straightforward deduction.
The death of a loved one can be overwhelming, especially if you inherit various types of assets from the estate that are treated differently for tax purposes. Income in Respect of a Decedent (IRD) refers to untaxed income that a decedent had earned or had a right to receive during their lifetime. This income typically comes in the form of a tax-deferred qualified retirement plan such as an inherited IRA, but can also include other employer retirement plans, inherited non-qualified annuities, employer non-qualified stock options, deferred compensation, and more.
IRD is taxed to both the estate and the beneficiary that inherits the income, which often leads to double taxation. In extreme cases, this income may be taxed at up to a 77% rate (40% estate tax in addition to a 37% ordinary income tax rate), which essentially diminishes most of the value of the income. However, a rule exists to avoid this double taxation. Typically, a beneficiary must pay ordinary income tax on income before they can receive their inheritance. However, with the IRD deduction (also known as the decedent deduction), beneficiaries are eligible for an income tax deduction on their individual return when the income becomes taxable (i.e. is withdrawn from the IRA account).
A beneficiary can get the decedent deduction on these inherited assets by showing that the estate already paid estate taxes on those particular income items. This deduction must be claimed at the time that distributions, along with the taxable income, are received from the IRA. However, an important thing to note is that the IRA distributions do not need to be used to pay the estate’s tax liability in order to receive the decedent deduction. The decedent deduction is claimed as a miscellaneous itemized deduction on Schedule A for individuals, but is not limited to the 2% AGI threshold – this means it was not eliminated by the Tax Cuts and Jobs Act.
If you failed to include this deduction when you filed your tax return you can file an amended return for any year within the statute of limitations to claim tax refund. The statute of limitations is currently 3 years from the date you filed your original return. The decedent deduction can be quite significant in magnitude, so this topic should be discussed with your tax preparer to see if it would be beneficial to file an amended return. While this deduction has the potential for large tax savings, it may also be difficult to calculate and track. If you have any questions regarding the decedent deduction, or any other tax matters, please feel free to contact us at (858) 558-9200.