If a person with an IRA or other retirement account is planning to leave the balance in the account upon death to an individual or his or her estate, there could be a tax due of some consequence. Often unexpectedly, the estate or the person receiving the balance is subject to a federal income tax. The tax is due because the balance is income in respect to a decedent (“IRD”).
Many retired people have comparatively large balances in their IRA or other retirement accounts. With the high minimum threshold for federal estate tax liability, and the comparatively low rate of the Pennsylvania Inheritance Tax, succession, not tax liability on death, is the major tax consideration in estate planning in 2018. However, since the graduated tax rates for federal income tax on estates start lower and increase faster than the tax rates on individuals, IRD can generate a significant amount of federal income tax in an IRA or other retirement account situation. Fortunately, there are several estate planning steps which can be taken to avoid the IRD tax or, at least, avoid the disappearance effect which taxing the balance all at once has on the effectiveness of the bequest as an investment vehicle for the heir.
First, if the owner of the account has a spouse, he or she can name him or her as a successor beneficiary on the account. In that case, the minimum distribution requirement for the IRA will be changed to that of the surviving spouse if his or her life expectancy is longer. Alternatively, the surviving spouse can start a new IRA and have the trustee of the decedent IRA make a balance transfer to the trustee of the surviving spouse’s IRA. In either case, the there is no taxable IRD because the successor has only a right to income, not the balance in the account. Although this alternative avoids the IRD tax and resulting immediate disappearance of potentially large amounts of investment principal for the designated beneficiary, it limits any flexibility in tailoring distributions to the financial needs of the successor beneficiary.
If the designated beneficiary of the decedent’s IRA is not a spouse, the beneficiary can elect to continue taking distributions over the life expectancy of the decedent. This is the classic stretch IRA. Again, there is no taxable IRD if the successor has only a right to income. The trustee to trustee transfer is also available if the successor has only the right to income. As with the spousal exception, this exception avoids the IRD tax and resulting immediate disappearance of principal, but still limits any flexibility in tailoring distributions to the financial needs of the designated beneficiary.
A third alternative is a designation by the owner of the account of a charitable organization described in IRC 501(c)(3) as the succeeding beneficiary. Because such a charity is exempt from federal income tax, no IRD tax would be levied on the charity. With this alternative, however, there is no way to take care of the financial needs of a noncharitable heir.
A fourth alternative is a designation of a charitable remainder trust (“CRT”) as the successor beneficiary. A CRT is also a federally tax-exempt entity so no IRD tax can be levied on it. A qualified CRT allows there to be an intervening noncharitable beneficiary who receives federally taxable income over his or her life or a period of time. Unlike an IRA, the rate of distribution from a CRT is not tied to life expectancy but is a fixed annual amount. If calculated initially, it is a charitable remainder annuity trust (“CRAT”) or a percentage of principal. If calculated annually, it is a charitable remainder unitrust (“CRUT”). Either a CRAT or a CRUT avoid the IRD tax and the resulting immediate disappearance of a large amount of principal. Especially, the CRUT has more estate planning flexibility for tailoring to anticipate the monetary needs of an heir, than using the successor IRA beneficiary exceptions.
The third and fourth alternatives also generate a federal estate tax deduction for the estate of a retirement account owner if it is needed. For a direct transfer to a charity, it is the amount of the balance. For a transfer to a CRT, it is the present value of the remainder interest.
With more and more people having retirement accounts, the possibilities of an unexpected IRD tax must be considered in an estate plan. Because the application of the tax can be avoided, a lawyer or accountant or other tax advisor should be consulted before naming a successor beneficiary of an IRA or other retirement account.
Spencer G. Nauman Jr., is the senior partner of the Harrisburg law firm Nauman, Smith, Shissler and Hall, LLP, Harrisburg’s oldest law firm. Mr. Nauman has been a lawyer with the firm for more than 40 years and his primary practice areas are corporate, probate/estate planning, taxation and insurance. Mr. Nauman represents several community foundations and the state community foundation organization. He is serving or has served as Director and President of business as well as community health, educational, and social service organizations.