Over the years, you may have made the most of tax-deferred investments. In many cases, this let you use the government's money to help compound the return that you had received. What if you don't plan to spend those dollars during your lifetime and prefer to let them grow for your beneficiaries? Without proper planning, you could end up leaving a big tax bill instead of financial security.
You might already know that when you die, your beneficiaries will owe income tax on distributions from your IRA, 401(k), and other retirement plans. However, did you realize that they will also have to pay tax on additional income that you were entitled to receive? This could include accrued interest on U.S. Savings Bonds, savings accounts and CDs; declared dividends; installment loan sales; and annuity and rental property income.
When you combine your heirs' potential income tax bracket and the possible estate tax rate, up to 82 cents out of every dollar you had hoped they would receive from your deferred accounts could disappear. And this does not include any state taxes that might apply. There is, however, a way to reduce this double-whammy tax bite. But it only works if your beneficiaries or their tax preparers know about it.
Income in Respect of a Decedent (IRD) is the term that the IRS uses for income that you earned but did not receive while living. And the government gives it a special tax break by allowing your heirs to deduct estate taxes paid on IRD when they calculate their income tax due on this income. As a result, the double taxation could possibly be eliminated.
For example, suppose you have a taxable estate and left your daughter an IRA that you had funded with deductible contributions. First, the amount that you had put in and all deferred income and appreciation will be subject to estate taxes. Then your daughter will have to pay income tax on each dollar she removes from the account. But if she takes advantage of the IRD deduction, each distribution from the IRA will be entitled to a tax deduction for the amount of estate taxes paid on that deferred income.
Besides telling your beneficiaries about the IRD deduction, there are other things that you can do to pass assets more tax-efficiently. Life insurance to pay estate and income taxes is one idea. Also you might want to consider giving property to your love ones while you are alive. Another thought is to use up your tax bracket by taking maximum distributions from your IRA. I always recommend investors consult their own qualified tax and financial advisor prior to making any investment decision.