Income in respect of a decedent is one of those arcane estate tax terms that only attorneys and tax experts can love. But IRD assets make up an increasingly larger share of estates, and failure to plan for them can cost an estate and its beneficiaries a lot of money. Income in respect of a decedent is taxable income the decedent earned during lifetime but had not received before death. For example, if a widow receives a bonus payment from her deceased husband's employer after the estate has been settled, it is reported on her income-tax return, not the decedent's final income-tax or estate returns.

Common IRD assets include distributions from retirement plans and individual retirement accounts (IRAs), unpaid installment payments, accumulated interest and dividends, lottery winnings, and untaxed gains in deferred annuities. Unlike many distributions from an estate that receive a "step-up" in basis, such as taxable stock or a home, or that aren't ordinarily treated as income such as insurance proceeds, IRD assets are subject to income taxes, in addition to estate taxes. This income-tax bite can prove a shock to beneficiaries who aren't aware of IRD treatment. Moreover, as estates accumulate more and more in retirement accounts and IRAs, the impact of IRD will grow. Fortunately, with proper planning and the use of an often overlooked income-tax deduction, the impact of income in respect of a decedent can be reduced. Perhaps the easiest way to at least delay the bite of much of the IRD is through the use of the spousal rollover. Naming the spouse as beneficiary of IRAs and retirement accounts generally postpones any estate tax on the inherited assets and slows down the imposition of income taxes on the payouts. For example, a surviving spouse receiving an IRA rollover from the deceased spouse can generally delay required minimum distributions from the IRA until he or she reaches the age of 70 1/2, and then payments can be stretched out over the survivor's remaining lifetime.

Naming a younger beneficiary to the survivor's IRA may further stretch out payments. Another technique is to funnel IRD assets into a credit shelter trust in order to avoid wasting the deceased's estate tax exemption. The IRD assets that work best for this are retirement plans or IRAs that allow regular payments instead of a single lump sum. Donating IRD assets to charity also can reduce the tax liabilities, though experts disagree about the benefits of donating IRD assets such as an IRA to a charitable remainder trust. Some feel it can provide fewer tax benefits than may first appear. As with any potential estate tax situation, having sufficient life insurance to pay any estate taxes also can help.

Where beneficiaries can really help themselves out, however, is to not overlook the IRD income-tax deduction. Here's how it works. Say you inherit a $2 million IRA from a parent who has a $4 million estate. First, the estate tax is calculated with all the taxable assets, including IRD assets such as the IRA. The estate tax might be roughly $900,000. Then you calculate the estate tax excluding the $2 million IRA, which might reduce the taxes to around $470,000. The difference between the two amounts is $430,000 and that represents the maximum IRD income-tax deduction that can be taken against the IRA distributions made to the beneficiaries. The deduction is treated as a miscellaneous itemized deduction, though it is not subject to the two percent of adjusted gross income floor to which miscellaneous deductions are normally subject. The deduction is not subject to the alternative minimum tax, but high-income taxpayers could lose some of the benefits to the three percent phase-out of itemized deductions. However, because IRA payments typically are spread out over a period of time, such as your life expectancy, the maximum deduction is also spread out over that period. So each year you'll deduct a portion of the IRA payout with a portion of the IRD deduction. If you don't use up the deduction before your death, it can be carried over to the heir of your IRA. As you might expect, this requires careful record keeping. If you've already missed IRD deductions, you can amend past returns to take it into account, but you can only amend back three years. Anything beyond that, you've lost.

This article was produced by the Consumer Affairs Dept. of The Financial Planning Association and provided to you courtesy of Nigel B. Taylor, CFP, Santa Monica, California. If you have any questions or concerns regarding this, or any other financial topic and are a resident of Southern California, please call me at 1-800-444-2237 (California residents only please), or click on the "MORE INFO" button to arrange for a free initial consultation in the comfort of your home or office.

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