Usually, a beneficiary who receives a distribution from an inherited qualified retirement plan (QRP) or individual retirement account has taxable income in respect of a decedent (IRD).1 If the retirement plan assets were included in an estate that incurred a federal estate tax liability (in 2013, an estate over $5.25 million), then their full value was subject to the federal estate tax. Courts have rejected arguments that the value of retirement assets should be discounted to reflect the substantial portion that’s essentially a deferred income tax liability that the beneficiary will incur in the year that she receives a distribution.2 Instead, the principal source of relief for the federal estate tax that was levied on the inflated value of retirement assets is found in Internal Revenue Code Section 691(c).
That section permits a beneficiary to deduct the federal estate tax attributable to IRD in the same taxable year that the IRD is included in the beneficiary’s income.3 If the beneficiary is an individual, the deduction is taken as an itemized deduction.4 An estate or trust that receives IRD can claim the IRD estate tax deduction without a comparable limitation,5 unless the IRD is required to be distributed to a beneficiary, in which case the deduction passes through to the beneficiary.
The statutes and regulations explain how the IRC Section 691(c) deduction is to be computed if an inherited retirement plan account is distributed to a beneficiary either in a single year or in the form of an annuity. Incredible as it may seem, there’s no legal authority that explains the correct way to deduct the applicable federal estate tax when a beneficiary receives uneven distributions over a period of years from an IRA or a QRP, even though this is probably the most common way that beneficiaries receive distributions from inherited accounts in the 21st century (for example, a “stretch IRA”). No law defines the portion of the distribution that’s attributable to IRD (which qualifies for the deduction), compared to the portion that represents investment income earned after the decedent’s death (which doesn’t qualify for the deduction).
Although several formulas are possible, the method that seems to have gained the widest acceptance is “first-in, first-out” (FIFO): a presumption that every distribution comes first from IRD until the entire IRD amount has been distributed.
A Simple Illustration
Assume that Dorothy is the sole beneficiary of her father’s estate. On the day that her father died in 2013, his wealth totaled $6 million, of which $5.5 million consisted of cash, stock and real estate and $500,000 was in an IRA. With $6 million of wealth and a $5.25 million estate tax threshold in 2013, $750,000 was subject to the estate tax. This triggered an estate tax liability of $300,000 (40 percent of $750,000), of which $200,000 was attributable to the $500,000 IRA. Even though the IRD assets only constituted 8 percent of his wealth, the tax laws provide that the IRD triggered 67 percent of the estate tax liability. This is because Section 691(c)(2)( c) provides that the estate tax attributable to the IRD is computed by comparing the amount of estate tax that would have been paid if the estate had no IRD, with the actual amount of estate tax that the estate paid with the IRD.
If Dorothy withdraws $100,000 from the IRA immediately after her father’s death, she should: (1) report the $100,000 as taxable income, and (2) claim an itemized income tax deduction of $40,000 for the estate tax attributable to the IRD. “What’s Left?” p. 33, describes the computation of her income tax liability. You can explain the Section 691(c) deduction to Dorothy in very simple terms by saying something like this:
The $500,000 in your father’s IRA is IRD. As you receive distributions, each dollar of IRD will be fully taxable to you. But, stapled to each of those dollars is a 40 percent income tax deduction. So the net effect is that you only have 60 cents of taxable income as you receive each dollar (oversimplified).
The $100,000 withdrawn immediately after her father’s death is IRD that qualifies for the 40 percent deduction. What about the remaining $400,000 of IRA assets? Suppose that Dorothy invests those assets and that she withdraws varying dollar amounts over many years. Finally, the IRA is liquidated, and over those years she’s received a total of $700,000—the original $400,000, plus $300,000 of investment income earned after her father’s death. How does she determine the portion of each year’s distribution that’s attributable to the $400,000 of IRD (which qualifies for the 40 percent Section 691(c) deduction), compared to the $300,000 from investment income earned after her father’s death (which doesn’t)?
Of the several possible formulas,6 FIFO is preferred. It has the advantage of simplicity. It’s the easiest number to compute and the easiest for the Internal Revenue Service to verify on an audit. Other methods would require annual mathematical exercises to attempt to identify the portion of each year’s distribution that was IRD, compared to investment income earned after death. And, from the taxpayer’s perspective, FIFO also has the advantage of generating the largest Section 691(c) deduction in the earliest years of distributions.
In some situations, FIFO may be the only possible method. A beneficiary might be unable to locate information about the amount of investment income that was earned each year after the decedent’s death. The courts have sometimes adopted a principle akin to FIFO (the cost recovery method) in a comparable situation in which a seller receives a payment for the sale of a portion of a large acquisition and can’t adequately allocate the underlying cost to that portion.7
Thus, in Dorothy’s situation, she should claim an itemized deduction of 40 percent for the first $400,000 distributed from the inherited IRA; then, the last $300,000 would be fully taxable without any offsetting income tax deduction.
Here are some other factors to consider concerning the Section 691(c) deduction:
1. Itemized on Schedule A. The deduction is itemized on Schedule A and claimed on the last line of the form (other miscellaneous deductions). It’s not subject to the 2 percent adjusted gross income (AGI) limitation, to which most miscellaneous deductions are subject.8
2. Effect of 3 percent haircut. Since it’s an itemized deduction, individuals who don’t itemize won’t benefit from the deduction. The reappearance in 2013 of the “3 percent haircut” (the reduction of itemized deductions by 3 percent for taxpayers with AGI over $250,000 ($300,000 on a joint return)) may cause many high income taxpayers to be unable to itemize, especially in states that don’t have a state income tax. For example, when the 3 percent haircut was in place in 2001, the percentage of taxpayers with AGI over $200,000 who claimed the standard deduction (and didn’t itemize their deductions) was 19 percent in Florida and 21 percent in Texas, compared to just 2 percent in California and 1 percent in New York.9
3. Long-term capital gain. Special rules apply when IRD consists of long-term capital gain.10 Capital gain income can occur, for example, when a beneficiary sells employer stock that had been distributed from that company’s QRP and the net unrealized appreciation (NUA) portion of the distribution qualifies for long-term capital gain treatment.11
4. Follows the income. The Section 691(c) deduction follows the income, even when it’s paid to a beneficiary who didn’t generate the income tax liability. Thus, for example, the deduction could be allocated to a spouse even when an estate claimed a marital estate tax deduction, and the Section 691(c) deduction can complicate the computation of the marital deduction.12
5. If beneficiary is a CRT. If the beneficiary of a retirement account is a tax-exempt charitable remainder trust (CRT), the IRS takes the position that the Section 691(c) deduction is fourth tier corpus, whereas the net taxable IRD is first tier taxable income. The net effect is that the beneficiary of the CRT will probably never get the tax benefit of a Section 691(c) deduction because it would be unlikely that the CRT would ever make a distribution from the fourth tier under most circumstances.13
6. Accelerating distributions. If an inherited IRA was subject to estate tax, then, to the extent that the beneficiary isn’t taking maximum advantage of other income deferral opportunities, she’ll often be better off accelerating distributions from the inherited IRA and then taking greater advantage of other opportunities. For example, assume that a beneficiary of an inherited IRA is employed at a business and that she’s not making any contributions to her 401(k) account. She could: (1) reduce her taxable income by electing to contribute the maximum annual amount ($17,500 in 2013, or $23,000 if over age 50) to her 401(k) account, while simultaneously (2) increasing annual withdrawals from the inherited IRA by the same amount. Her AGI would be the same, but her taxable income would be reduced. By increasing distributions from the inherited IRA, she can extract the 40 percent Section 691(c) itemized income tax deductions faster, thereby accelerating her tax savings.
7. Severe taxation of assets. Although the beneficiary might view an inherited IRA as a source of tax-favored income because of the offsetting 40 percent itemized income tax deduction, the bigger picture shows that these assets are subject to severe taxation—an effective federal tax rate of up to 67 percent from a combination of estate and income taxes (see “What’s Left?” p. 33). The rate can be nearly 80 percent if the beneficiary can’t itemize deductions. And, any state income taxes or state estate or inheritance taxes are extra!
Rather than leave 20 percent or less of the assets to taxpaying family members, an individual might make more effective use of the assets by leaving 100 percent of them to a tax-exempt charity with instructions to apply them to a specific charitable purpose that was important to the individual during her lifetime.14
Another option that may even appeal to the children of an estate-planning client is to name a donor advised fund (DAF) or a private foundation (PF) as the beneficiary of the retirement accounts. The decedent’s children can then have 100 percent of the assets applied toward charitable purposes that are important to them, compared to trying to be philanthropic with just a small fraction of those assets after estate and income taxes. A large DAF or PF can also increase a child’s prestige as a significant contributor to the community. A bequest to a DAF or to a PF may be the most effective way for an individual to transfer retirement assets to benefit both her descendants and the community at large.
1. Revenue Ruling 92-47, 1992-1 C.B. 198; Estate of Kahn v. Commissioner, 125 T.C. 227, 232 (2005); and Cutler v. Comm’r, T.C. Memo. 2007-348.
2. Estate of Smith v. United States, 391 F.3d 621, 626 (5th Cir. 2004); Estate of Doris F. Kahn v. Comm’r, 125 T.C. No. 11 (2005); and Estate of G.R. Robinson v. Comm’r, 69 T.C. 222 (1977).
3. Internal Revenue Code Section 691(c)(1)(A); Treasury Regulations Section 1.691(c)-1(a); Rev. Rul. 92-47, 1992-1 C.B. 198 (Holding 2).
4. IRC Section 67(b)(7) and Rev. Rul. 78-203, 1978-1 C.B. 199.
5. Treas. Regs. Section 1.691(c)-2(a)(3).
6. Christopher R. Hoyt, “Inherited IRAs: When Deferring Distributions Doesn’t Make Sense,” Trusts & Estates (June 1998), at p. 52.
7. Under the cost recovery method, a seller applies receipts toward the seller’s cost basis (for example, the entire purchase price) and doesn’t report taxable income until the cumulative receipts exceed the purchase price. For example, assume that a junkyard purchased an auto for $500 and dismantled the car to sell the parts (stereo, radiator, muffler, etc.). There’s no rational way to allocate the $500 purchase price to the various parts. Under the cost recovery method, the seller would report no taxable income until the sales proceeds exceeded $500. After that point, all future sales proceeds would become fully taxable. Burnet v. Logan, 283 U.S. 404 (1931); Estate of Wiggins v. Comm’r, 72 T.C. 701 (1979); Mothe Funeral Homes v. U.S., 95-1 U.S. Tax Cas. (CCH) Par. 50, 248, 75 A.F.T.R.2d (RIA) 2103 (E.D. La. 1995) (cost recovery method for sales of burial plots).
8. IRC Section 67(b)(7).
9. Michael Parisi and Scott Hollenbeck “Individual Income Tax Returns, 2003,” Statistics of Income Bulletin, Internal Revenue Service (Fall 2005), at. p. 13.
10. If the income in respect of a decedent (IRD) consists of a long-term capital gain, then the IRD deduction is applied to reduce the long-term capital gain (which in 2013 might be taxed at a rate of only 15 percent or 20 percent), rather than a deduction against ordinary income, when the taxpayer might obtain a benefit at a higher marginal tax rate. IRC Section 691(c)(4).
11. IRC Section 402(e)(4).
12. Estate of Nellie Kincaid v. Comm’r, 85 T.C. 25 (1985); Estate of Wendell Cherry v. U.S., 87 A.F.T.R.2d Par. 2001-485 (W.D. Ky. 2001); and Private Letter Ruling 200316008 (Dec. 31, 2002) (payments to a surviving spouse).
13. PLR 199901023 (Oct. 8, 1998).
14. Many of the opportunities and hazards of using individual retirement account and qualified retirement plan assets for charitable bequests have been analyzed in previous articles in Trusts & Estates. See, for example, Christopher R. Hoyt, “Treacherous Waters,” (January 2009), at p. 15.