Tax Breaks for IRA and Plan Beneficiaries

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NUA and 10-year averaging tax breaks also apply to beneficiaries (if decedent would have qualified, had he lived to take advantage of them).
IRA beneficiaries are generally unaware of the special tax breaks they are entitled to. As a result, they rarely take advantage of them and tend to overpay their taxes. Professional tax preparers miss these items, too, because they are either so buried with work during tax season when these beneficiaries often have their returns prepared, or because theydon’t think to ask about these little known items.

Some IRA beneficiaries qualify for a tax deduction for Income in Respect of a Decedent (IRD), also known as the estate tax deduction. IRD is income that was earned by the decedent, but collected by the beneficiary. The beneficiary pays the income tax when the income is collected. Prime examples of IRD include IRAs, 401(k)s, and annuities. IRD items are included in the decedent’s estate and are subject to estate tax, and then are also taxable to the beneficiary as income when the IRA (or other IRD item) is paid out to the beneficiary. That’s double taxation—estate and income tax—and it’s legal. The IRD deduction partially offsets the double tax by allowing the beneficiary an income tax deduction for the amount of federal estate tax paid on the IRD item.

This is a big break for beneficiaries claiming the deduction. It is valuable to the beneficiary because it is usually about a 40% tax deduction (it will likely be less for beneficiaries who inherit in 2011 or later years since the federal estate tax exemption is larger. But the estate tax rate increased to 40% for 2013 and later years.) That’s 40% of the amount of the IRA withdrawal. If the beneficiary withdraws $100,000 from the inherited IRA, he could be entitled to a $40,000 tax deduction (40% of the $100,000 IRA withdrawal).

The deduction is claimed on the beneficiary’s personal tax return as a miscellaneous itemized deduction. It is not subject to the 2% adjusted gross income limitation and is not subject to alternative minimum tax. However, it is subject to the overall 3% itemized deduction limitation which is effective in 2013 and later years.

The IRA beneficiary takes the IRD deduction as he withdraws from the IRA. Not every beneficiary can claim this deduction. If there was no federal estate tax, then there is no IRD deduction.

Keep track of IRA basis. Basis carries over to beneficiaries.

If the person who owned the IRA had basis, the beneficiary inherits that basis in the IRA. In an IRA, making nondeductible IRA contributions creates basis. When basis is withdrawn, there is no tax because no deduction was ever taken. But most beneficiaries do not even know to ask. To find out, a beneficiary will have to know if the person they inherited from ever made any nondeductible IRA contributions. They can discover that by looking for Form 8606 (Nondeductible IRAs) attached to any of the deceased IRA owner’s income tax returns. Form 8606 shows the basis (the amount of nondeductible IRA contributions made).

If there is basis, then as the beneficiary withdraws from the inherited IRA, that portion of the withdrawal that is a return of the basis is tax free, the same as it would have been for the person it was inherited from. It is rare that even a professional tax preparer thinks to ask if there were any nondeductible IRA contributions made by the deceased IRA owner.

If no Form 8606 is found, it does not automatically mean that no nondeductible IRA contributions were made. It may mean that the form was never filed. You can still find any nondeductible contributions by checking IRA statements to see when contributions were made. You may also be able to track down Form 5498 for prior years, which would also show if IRA contributions were made. Then you look at the tax return for the year of the contribution to see if a deduction was claimed for that IRA contribution. If not, then you can assume that a nondeductible contribution was made. Keep any documentation after the return is filed in case IRS asks you to show how you came up with the amountof nondeductible contributions. Nondeductible IRA contributions began in 1987, so do not bother checking returns for prior years.

To claim the tax-free portion of distributions from an inherited IRA, a beneficiary will also have to file Form 8606, just as the IRA owner did.

The basis for the federal return may be different from the basis a beneficiary can claim on the state tax return. The deceased IRA owner may have received a federal tax deduction for his or her IRA contribution, but may have filed state taxes in a state that does not allow a deduction for IRA contributions. If that is the case, then for state tax purposes the IRA distribution may be partially tax free, even though it may have been fully taxable on the federal tax return.

This is not only for IRA beneficiaries. Clients should also check to see if their IRA contributions were deductible on their state tax returns. If not, they have state basis, and part of their IRA distributions may be tax-free on the state tax return.

All Roth IRA contributions are nondeductible, so if clients have inherited a Roth IRA, all of the contributions are basis and can be withdrawn tax-free. The earnings can also be withdrawn tax-free, as long as any Roth IRA was held for more than five years (including the time the deceased account owner held the Roth IRA).

Danny inherits a Roth IRA in 2012 from his Aunt Edna. She first contributed to her Roth IRA in 2009 and died in 2012. All distributions of contributions are tax-free whenever they are withdrawn, but the income is not tax-free until 2014, when the Roth IRA will have been held for more than five years.

Assume Aunt Edna contributed $6,000 to the Roth, and the Roth is now worth $7,000. If Danny withdraws the entire balance—$7,000—in 2013, then $6,000 will be tax-free and the $1,000 of income earned will be taxable. If he withdraws only $6,000 in 2013, it is all tax-free, since IRS rules say that the contributions are the first dollars withdrawn. If he withdraws all $7,000 in 2014, then it is entirely tax-free, because the Roth IRA has been held more than five years. Even though Danny, the beneficiary, has not held the Roth for more than five years, he adds the time it was held by his aunt.

If clients have inherited a company retirement account—for example, a 401(k)—and they took a lump-sum distribution from the plan last year, they may be entitled to special tax breaks that would have been available to the person they inherited from, had he or she survived. If the plan participant would have qualified for special tax treatment on a lump- sum distribution, then the beneficiary also qualifies for the tax breaks, regardless of age. The tax breaks available on lump-sum distributions are NUA (Net Unrealized Appreciation), 10-year averaging, and the pre-1974 Capital Gain Election.

For example, to qualify for 10-year averaging a plan participant must have been born before 1936. But if clients inherit from someone born before 1936 who would have qualified for 10-year averaging, then they also qualify, regardless of their age. The same is true if they want to take advantage of the NUA break. If there was company stock inthe plan, a beneficiary only pays tax on the cost of the stock when it is withdrawn in a lump-sum distribution. The difference between the cost and the current value of the stock when you withdraw it (the NUA) will not be taxed until you sell that stock. When a beneficiary sells the stock, they only pay capital gains tax rates at the current rates. The NUA is a big tax saver when stock has greatly appreciated since it was purchased in the plan.

As of 2010, plans must allow all non-spouse beneficiaries to do a direct rollover of the inherited plan funds to a properly titled inherited IRA or inherited Roth IRA. Non-spouse plan beneficiaries can lighten the tax burden of a distribution or conversion to an inherited Roth IRA by taking advantage of the NUA and 10-year averaging tax provisions that are available for qualifying lump-sum distributions (as long as the plan participant would have qualified).

There is also a special tax break if any of the lump-sum distribution is from plan participation before 1974. The provision is known as the “Capital Gain Election,” but the tax rate on the pre-1974 amount stays at 20%.

The bottom line: non-spouse plan beneficiaries who took a lump-sum distribution or converted to an inherited Roth IRA may as well see if they can use any of these tax breaks and pay less tax. Use Form 4972 (Tax on Lump-Sum Distributions) to report the lump-sum distribution received and to claim the tax breaks for 10-year averaging and the capital gain election, if they qualify. NUA is only reported on this form if it is used in conjunction with 10-year averaging.

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