Your clients likely appreciate how you have helped them amass their nest egg. Feeling more secure, their focus may well shift to determining how to pass along those assets to their heirs. Many clients have concentrated wealth within retirement accounts that they will not need to spend during their lifetimes. It is your job to help your clients decide how to handle those assets. Should they just name their spouse, children, or a trust as beneficiary? What are the tax ramifications of passing on retirement accounts?
Due to the current publicity on estate tax legislation, many clients may be taking a "wait-and-see" approach to estate planning. While I cannot predict what our estate tax system will look like in the future, I do know that clients should address now a number of planning issues to maximize the value of assets that will pass to heirs.
One issue that is often overlooked during planning discussions is how best to plan for assets that are subject to income in respect of a decedent (IRD). IRD can be confusing, but I hope this discussion will add some clarity, in addition to presenting you with some new planning opportunities.
What Is IRD?
Treasury regulations define IRD as "those amounts to which a decedent was entitled as gross income but which were not properly includable in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent" (Treas. Regs. ? 1.691(a)--1(b)). So, with this definition and Internal Revenue Code Section 691, we are left to identify and administer assets that, upon the owner's death, will produce an immediate ordinary income tax liability to the recipient of the asset. Rather than being solely concerned with planning for estate tax liability that assets may create upon a client's death, it is important to recognize IRD items when implementing a plan for an efficient final distribution to heirs.
Implementing a client's estate plan requires more than retitling a few brokerage or investment accounts into the name of a trust. As the investment expert on a client's estate planning team, you must understand the roles that certain assets will play within the plan and how to best position those assets. IRD items require extra attention, but with some planning, the impact from the immediate ordinary income tax liability to the recipient can be lessened.
Examples of some typical assets or agreements that are IRD items include deferred compensation plans (both qualified and nonqualified), U.S. savings bonds, annuities, and uncollected payments prior to death under an installment sale. The identification of IRD items reaches far beyond these examples, but, for this discussion, I am only focusing on qualified deferred compensation plans and similar retirement accounts that are commonly a significant portion of client assets.
IRD and the Estate Tax
Under IRC Section 691, tax paid on IRD items provides an income tax deduction in relation to the federal estate tax paid on the portion of IRD items included in the gross estate. Unlike most property, which includes a step-up in basis upon the death of the owner, IRD items do not receive this step-up and are thus subject to estate and income taxation. The estate tax deduction attributable to IRD items provides some form of reprieve from the double taxation that would otherwise exist if not for the deduction. In many cases, however, the deduction from estate tax attributed to IRD items does not place the value of the estate in the same position as it would be with prior planning for disposition for IRD items.
Determining the true value of the estate tax deduction requires you to analyze the marginal tax rate of the recipient of the IRD item and the estate tax rate applied to the gross estate, among other factors. Moreover, because no portion of state death taxes paid is deductible for federal income tax purposes, you must consider the tax laws of each client's particular state. Although there is a federal estate tax deduction for IRD items, the only way to ensure the value of the estate is maximized for the heirs is with prior planning for those same IRD items.
What's the Plan?
Because retirement accounts are some of the most common IRD items among client assets, I will focus this discussion on how to help mitigate the tax liability that is inherent in passing those assets to heirs.
Typically, the surviving spouse is named as beneficiary of a retirement account--and for good reason. Not only is he or she generally afforded the continued tax deferral from rolling the deceased spouse's account balance into their own account, but, due to the unlimited estate tax marital deduction, immediate realization of IRD and estate taxation are also deferred (Treas. Regs. ? 2056(a)). Although the estate tax and IRD is initially avoided by passing along the retirement assets to the surviving spouse, the tax liability is only temporary. Upon the death of the second spouse, both estate tax and IRD will eventually be incurred by the non-spouse beneficiaries. This is where planning for IRD items can pay off for clients interested in maximizing the ultimate value of assets to pass to heirs.
Planning to lessen the impact of IRD to non-spouse beneficiaries requires consideration of each particular beneficiary's tax status. If the gross estate consists of both IRD and non-IRD items, it may be beneficial to name beneficiaries with a lower marginal tax rate to the retirement account, which will ultimately reduce the amount paid in income tax. A bequest of non-IRD items within the gross estate to those heirs in higher marginal tax rates will create a step-up in basis as of the date of death, and any appreciation thereafter would be capital gain versus ordinary income tax inherent with IRD items.
The beneficiaries named to the retirement accounts can lessen the effect of IRD by extending the time period over which they take distributions. A beneficiary who chooses to take distributions over her life expectancy may offset the effects of IRD liability by allowing remaining balances an extended period to continue tax-deferred growth. This is not a complete solution, however, due to the beneficiary's ability to take a lump-sum distribution at any time.
By drawing down the balance of the retirement account during the accountholder's lifetime, there will be less IRD liability to beneficiaries when the accountholder passes away. Obviously, this requires that the accountholder realizes ordinary income on each distribution from the retirement account, but the after-tax distribution can be used to purchase life insurance in an irrevocable life insurance trust (ILIT). From an estate tax view, the ILIT also allows for a reduction of the gross estate of the accountholder as premiums and death benefits paid upon the death of the insured are removed from the estate. The beneficiaries will reap the benefits of receiving a tax-free death benefit while reducing the decedent's estate.
Some charitably minded clients may want to consider naming a charity as beneficiary (see "The Charitable Solution" sidebar), but other clients may focus on maximizing the value of assets to pass along to their children or other heirs. If a client has accumulated a large retirement account balance that will not be needed for living expenses, then he or she may want to consider taking distributions during their lifetime and making gifts to the ILIT where their children are named as beneficiaries of the trust.
Some clients who choose to use an ILIT in conjunction with after-tax gifts of retirement distributions may also incorporate naming a charity as beneficiary to remove any remaining retirement assets from the estate. The accountholder's heirs stand to receive a substantial benefit from the ILIT, while the charity as beneficiary will further reduce the size of the gross estate, therefore reducing the estate tax burden. Of course, the use of an ILIT is dependent upon the insurability of the accountholder. The benefit of using an ILIT will be greatly reduced if the client's age and health make the use of insurance too costly when compared to the benefits.
Many advisors and clients fail to recognize the impact of IRD items within an estate plan. With your help, and some planning, your clients may be able to maximize the assets that will ultimately pass to their heirs.
IRD is a complicated area of tax law that requires the advice of a qualified tax professional. As always, planning should not be done in a vacuum: all financial plans should be reviewed and coordinated with the client's estate planning attorney and tax professional.
Gavin Morrissey, JD, is an advanced planning consultant in Wealth Management at Commonwealth Financial Network in San Diego, CA. He can be reached at firstname.lastname@example.org.