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:
Is the distribution fully includible in income?
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:
- Fiscal year. The executor can choose a fiscal year (within limits). While required minimum distributions are always based on the calendar year, the estate may be able to get a bit of tax deferral for those distributions by using a fiscal year. For example, if the estate's fiscal year ends March 31, a 2021 required minimum distribution taken in December 2021 will be includible in the estate's income for its year ended March 31, 2022. If that distribution was passed out to the individual estate beneficiaries, they will report it as received in 2022.
- 645 election. If the decedent had a revocable living trust, it can be advantageous to file a Section 645 election, whereby the estate and the trust are treated as a combined entity for income tax purposes during administration of the estate. This election enables the trust to use the estate's fiscal year during administration. (Normally, trusts must use the calendar year for income-tax-reporting purposes.)
- The IRD deduction. Retirement plan distributions are income-taxable to the recipient as "income in respect of a decedent" under Section 691 of the tax code. If the estate is large enough to be subject to federal estate tax, the federal estate tax paid on the retirement benefits can be deducted for income tax purposes when those benefits are paid out. This is nicknamed the IRD deduction. For example, if a $1 million IRA is included in the estate for estate tax purposes, the estate as beneficiary of the IRA could have as much as a $400,000 IRD deduction to offset the $1 million of income generated when the estate cashes out the IRA. The deduction as a percentage of the total IRA value is largest at the time of death (assuming the IRA keeps growing after that date).
- Elections. Certain expenses paid by the estate can be deducted either on the estate tax return or on the estate's income tax return. Some expenses can be deducted on the decedent's final income tax return rather than on the estate's return. Decisions regarding when to pay and where to take these deductions should be made with the retirement benefits in mind.
Distributions to carry out income
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):
- Is the executor permitted to make the distribution at this time? Under some states' laws, distributions to beneficiaries cannot be made until a period of time has elapsed for creditors to file their claims or until tax liens have been settled. Sometimes a will contest causes estate distributions to be frozen by a court.
- Pecuniary bequests. There is generally no DNI deduction for payment of a "pecuniary" (fixed dollar amount) bequest. The will says "pay Jimmy $100,000 upon my death." The executor takes $100,000 out of the IRA and pays it to Jimmy. That distribution is not deductible because this is a pecuniary bequest. The estate (not Jimmy) will be stuck with the income tax on the IRA distribution.
- Separate share rule. If there are multiple residuary beneficiaries (as in "pay the residue of my estate equally to my children A, B, and C"), any retirement plan distribution received by the estate will generally be allocated proportionately among their shares for DNI purposes. Suppose the executor pays out all the IRA money to Child A (because A is in a low tax bracket) and distributes other assets of equal value to B and C. Unless the will required that A's share be funded with the IRA, the DNI generated by the estate's receipt of the IRA proceeds will be carried out pro rata to all three children. Because of the separate share rule, B's and C's shares will each be stuck with one third of the income tax liability on the IRA distribution even though only Child A actually received IRA proceeds from the estate. Can the executor avoid the "separate share rule"? See number five below.
- No DNI deduction for charity. There is no DNI deduction for payments to charity. A distribution from the estate to a charity is deductible, if at all, only under the stricter requirements applicable to the fiduciary charitable deduction (Tax Code Section 642(c)). If the will specified that the charity's share must be funded with the retirement benefits, that could make the distribution tax deductible; otherwise, the only way to avoid the no-DNI-deduction rule for distributions to charity is to follow number five, below.
- Transfer the plan itself, not the distribution. An IRA that is payable to the estate can be transferred, intact, out of the estate to one or more residuary beneficiaries of the estate. Such transfers are allowed by the tax code and by many but not all IRA providers. When an IRA is transferred to a residuary beneficiary, the transfer does not generate income to the estate nor does it "carry out DNI" to the beneficiary. The beneficiary simply takes over the inherited account as part of his, her, or its share of the estate. This move can help the executor avoid the "separate share rule" (see number three, above) and the limits on fiduciary income tax charitable deductions (see number four). This type of transfer is probably not available for non-IRA retirement accounts.
Have we covered every possible income tax consideration? Probably not, but this is a good start!