The Executor’s Guide to Retirement Plan Distributions: Income Taxes
Continuing a look at issues executors face when retirement benefits are payable to the decedent’s estate.
When retirement benefits are payable to a decedent’s estate, what unique obligations and opportunities does the executor of the estate have with respect to those benefits?
Last month, we looked at the executor’s responsibilities regarding required minimum distributions for such benefits as “Part 1” of my answer to the above question from an advisor. This month, we look at the income tax implications of taking distributions from a traditional retirement account. This brief summary is meant as an issue checklist, not a complete explanation, and does not cover Roth plans.
When an IRA or other traditional retirement account is payable to an estate, the estate faces a potentially large income tax hit as those accounts are liquidated and distributed to the estate. The federal income tax rate applicable to an estate’s income is 37% on taxable income in excess of $13,050 (2021 rates). On top of that is the federal tax of 3.8% on net investment income; although not directly applicable to retirement plan distributions, it applies to the estate’s investment income if the estate’s taxable income exceeds $13,050. The retirement plan distributions do count for purposes of determining whether the estate is over the threshold. State income tax may also apply.
The executor may be able to mitigate that tax hit through timing of income (plan distributions) and deductions (such as payment of deductible expenses), choices regarding fiscal year and other administrative elections, and passing out the plan distributions (or the retirement account itself) to estate beneficiaries. But first the executor must determine:
Most distributions from non-Roth retirement accounts will be fully includible in the estate’s gross income, but there are exceptions. For example, if the decedent had made aftertax contributions to the retirement account, the proportionate amount of the distribution representing aftertax money will be nontaxable. Unfortunately, there is no way for the executor to withdraw just the aftertax money--the tax code states that distributions carry out the pre- and aftertax money proportionately. All of the decedent’s IRAs are considered a “single account” for purposes determining the pre- and aftertax proportions. The executor will have homework to do, figuring out the decedent’s aftertax contributions from the decedent’s or plan’s records.
If the distribution is from a qualified plan such as a profit-sharing plan, and the plan investments include stock in the employer company, the estate may qualify for special tax treatment with respect to the net unrealized appreciation inherent in that stock: The tax on the NUA is deferred until the stock is later sold, then paid at capital gain rates. To qualify for this treatment, the estate must take a “lump sum distribution” that includes the stock. This would mean (1) not selling the stock while it is still inside the decedent’s plan account, and (2) taking distribution of the entire account in one taxable year. Because the special tax treatment of NUA can be very favorable, the executor should seek expert advice before taking any distributions from a company plan that owns employer stock.
Another (very rare) tax break can apply to a “lump sum distribution” from the account of an employee who was born before 1936. If your decedent may have qualified for that treatment, investigate it with a tax expert before taking any distribution from the plan.
Once past the above issues, the executor is looking at distributions that are straight up 100% includible in the estate’s gross income as “ordinary income.” How can the executor diminish the tax impact of that income?
Administrative matters affecting the tax impact
Administering an estate with an eye to minimizing income taxes on substantial retirement benefits is a chess game. The executor needs to carefully time the receipt of plan distributions (to the extent the executor has a choice on that) so as to match those receipts with deductions the estate can take. The executor should hire an accountant who is an expert in fiduciary income taxes. That hiring, and the planning discussed here, should begin sooner rather than later. If the executor waits until after the retirement account has been cashed out or until it’s time to file the estate’s income tax return, it will probably be too late.
For a good introductory course on deductions the estate can take for payments of expenses and distributions to beneficiaries, start with IRS Publication 559, Survivors, Executors, and Administrators. Then consider the following additional points:
Most practitioners are aware that generally a distribution from an estate to a beneficiary of the estate “carries out” a corresponding amount of the estate’s “distributable net income.” The estate gets to deduct that distribution (the DNI deduction), and the beneficiary then has to pay tax on the income so passed out to him. Since the estate is virtually always in the highest tax bracket, the executor will look for ways to reduce the income tax hit on the retirement benefits by passing that income out to the beneficiaries if they are in a lower bracket than the estate. The executor might even want to steer the taxable income to particular beneficiaries who are in lower tax brackets than other beneficiaries ... or, if the estate beneficiaries include one or more charities, even pass out the IRA distributions to the tax-exempt charities, using other less tax-laden assets to fund the shares of the individual beneficiaries.
These are important goals and strategies, but implementation is not simple: Even if the strategies are permitted under the governing instrument, the executor should not be lulled into thinking he can always reduce the income tax impact of retirement plan distributions any old time by just making a distribution to beneficiaries. Here are four obstacles you don’t want to find out about after you have already taken the distribution from the retirement account (and at number five, a way to sidestep two of them):
Have we covered every possible income tax consideration? Probably not, but this is a good start!