Volume 13, Number 3 · July 2003

What Will The IRS Say About The IRD In Your IRA?

By Kenneth L. Baker

Most people are aware when retirement contributions are made by them or by their employer to a 401(k) plan or to an Individual Retirement Account that those contributions were excluded from income at the time the contributions were made. Most people also understand that as they withdraw from their 401(k) plan or IRA that Income Tax must be paid on the money which is withdrawn. Finally, most people understand that if you make a withdrawal from your retirement plan prior to 59 1/2 years of age you will suffer a penalty and if you fail to make appropriate withdrawals under the Minimum Distribution Rules after one turns 70 1/2 years that a penalty will also be assessed.

What is not commonly known is that if you die your IRA is part of your taxable estate. As a result, Federal Estate Tax and Pennsylvania Inheritance Tax, if you are over 59 1/2, is due on the IRA. The proceeds of the IRA are considered "income in respect to a decedent" or what is known as "IRD." A deduction is created based upon the Federal Estate Tax paid related to the IRA when withdrawals or payments are made from the IRA to the decedent's beneficiaries. Other examples of IRD are installment sale notes and savings bonds.

Estate planners will often talk about IRAs or pension assets as being "hot assets". That means they are going to be taxable for Income Tax purposes upon withdrawal and will be taxable for both Pennsylvania Inheritance Tax and Federal Estate Tax purposes in one's estate. In terms of Federal Estate Tax this assumes that one has an estate over $1 million dollars in the year 2003 or $1.5 million in 2004. The applicable credit will increase again to $2 million in 2006 and to $3.5 million in 2009 before the Federal Estate Tax theoretically goes away in the year 2010. If no action is taken the Federal Estate Tax comes back in 2011 with a $1 million dollar applicable credit

When one realizes that a large IRA is going to be taxed for (1) Income Tax purposes at the rate of tax one is paying at the time of withdrawal, which could be as much as 35 percent, and is then subject to (2) Pennsylvania Inheritance Tax at a rate somewhere between 4-5 percent and 15 percent and finally is subject to (3) Federal Estate Tax at a rate beginning at 37 percent up to possibly 49 percent, the initial reaction is that most if not all of the IRA will disappear, Congress recognized this problem and created what is known as the "IRD" deduction. The purpose of the "IRD" deduction was to allow an individual to deduct a proportionate amount of the Federal Estate Tax paid on the IRA as the IRA is distributed. This deduction reduces the impact of double taxation.

Studies have been done to determine the total tax rate. If an individual is in the top bracket for Estate Tax and the top bracket for Income Tax not taking into account Pennsylvania Inheritance Tax, there is an effective combined tax rate of over 76 percent. This will diminish in the year 2007 through 2009 to 64.25 percent. As an example out of $100,000.00 in the decedent's IRA if the decedent is in the top Federal Estate Tax bracket and an heir is in the top Income Tax bracket, the heir would be left with just $23,651.00.

In most cases IRAs are payable to the surviving spouse and then rolled over by the surviving spouse into their own IRA. This defers the Federal Estate Tax and Pennsylvania Inheritance Tax but continues to result in Income Tax when the surviving spouse makes the minimum required (or larger) withdrawals. On the surviving spouse's death the whole amount remaining becomes subject to Federal Estate Tax and Pennsylvania Inheritance Tax and to Income Tax at the time of withdrawal.

The impact of IRAs in terms of percentage of assets in the gross estate are larger in the moderate estates (for instance $1 million to $2-5 million estates) than IRAs are in larger estates. This is due to the fact that wealthier taxpayers have substantial other assets that are not related to IRAs or pension plans while many middle income taxpayers currently retiring build up large retirement plans but not large assets otherwise.

The IRS has by recent regulations attempted to reduce the minimum required distributions and to permit a payout over the life expectancy of beneficiaries to ameliorate the impact by spreading the income tax cost. If the beneficiary is able to take only the minimum required distributions rather than lump sum amount the income can be spread out. In some cases an heir is not able financially to afford to spread out payments over the maximum length of time and thereby minimize the Income Tax.

One way to attempt to minimize the impact of Federal Estate Tax, Pennsylvania Inheritance Tax and Income Tax is to give all or a part of one's IRA to a charity. The result is that the IRA is not taxable for Federal Estate Tax; Inheritance Tax or Income Tax purposes because it passes to a tax exempt entity. Because IRAs represent in many cases a large portion of the individual's assets and are important to provide income and assets to the surviving spouse and to fulfill the desire to eventually give those assets to the individual remaining beneficiaries, many individuals are reluctant to name a charity as a beneficiary of an IRA.

One strategy that is often used to provide the benefit of avoiding the triple taxation of IRA assets as well as providing income and assets to the surviving spouse and beneficiaries is to create what is known as an Asset Replacement Trust. This is an Irrevocable Life Insurance Trust (ILIT) which purchases life insurance on the IRA owner's life in either an amount equivalent to or larger than the IRA. This ILIT can then be set up to pay the income and if necessary the principal for the benefit of the surviving spouse during his or her lifetime with the remainder over to the heirs. If the ILIT is properly established and the payment of premiums is properly done the insurance in the ILIT is not taxable for Federal Estate Tax or Pennsylvania Inheritance Tax purposes since the decedent had no incidents of ownership in the Trust. For that to occur it is recommended that the Trust be established before the insurance is purchased, that the insurance be purchased by the Trustee, that the insurance be payable to the Trust and that special rules be followed for the individual who establishes the Trust to give sufficient funds to pay the premiums for the insurance. The ILIT can permit substantial tax savings.

Obviously, the trade off to naming a charity as the beneficiary of your IRA is that one has to pay insurance premiums to provide the funds in the Asset Replacement Trust. Whether this strategy will work is a function of an individual's age, health, the size of the individual's IRA, their charitable inclinations, etc. Therefore, before one follows this strategy it is important for one to consult with experienced counsel who can analyze the benefits of this strategy and who in consultation with the client can determine whether this plan meets the client's wishes and is in the client's best interest. If you are interested in this estate planning strategy, please feel free to contact our estate planning counsel.

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