IRDs and Retirement Accounts

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.

Summing Up

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 [email protected].