If retirement benefits are paid to a testator’s estate, what are the special obligations and options for the administrator of the estate with regard to these benefits?
Last month we looked at the executor’s responsibilities in relation to minimum payouts required for such benefits as “Part 1” of my answer to an advisor’s question above. This month we look at the income tax implications of making distributions from a traditional retirement account. This brief summary is intended as a checklist of issues, not a complete explanation, and does not include Roth’s plans.
When an IRA or other traditional retirement account is payable to an estate, the estate faces a potentially large income tax burden as these accounts are liquidated and distributed to the estate. The federal income tax rate applicable to income from an estate is 37% on taxable income greater than $ 13,050 (2021 rates). In addition, there is a federal tax of 3.8% on net investment income; While not directly applicable to retirement plan distributions, it does apply to the estate’s investment income if the estate’s taxable income exceeds $ 13,050. The pension plan distributions count towards determining whether the estate is above the threshold. State income tax may also apply.
The executor can possibly manage this tax burden by coordinating income (plan distributions) and deductions (z) to beneficiaries of the estate. But first the executor must determine:
Is the distribution fully included in the income?
Most distributions from non-Roth retirement accounts are fully included in the gross income of the estate, but there are exceptions. For example, if the testator has made post-tax contributions to the pension account, the pro-rata amount of the distribution, which represents post-tax monies, is not taxable. Unfortunately, there is no way for the executor to just withdraw the money after tax – the tax law says that distributions take the money out proportionally before and after tax. All of the testator’s IRAs are treated as a “single account” for purposes of determining pre- and post-tax shares. The executor must do homework and determine the testator’s post-tax contributions from the testator’s records or plan.
If the distribution is from a qualifying plan, such as a profit-sharing plan, and the plan assets include shares in the employer company, the estate may be treated separately for tax purposes with respect to the net unrealized appreciation contained in that share: tax on the NUA is deferred until the share is later is sold and then paid out at capital gains rates. To qualify for this treatment, the estate must make a “flat-rate distribution” that includes the inventory. This would mean (1) not selling the stock while it is still in the testator’s plan account, and (2) distributing the entire account in one tax year. Since NUA’s special tax treatment can be very beneficial, the executor should seek professional advice before accepting distributions from a business plan with employer shares.
Another (very rare) tax relief can apply to a “lump sum distribution” from the account of an employee born before 1936.
Once the above problems have been overcome, the executor will consider distributions that are 100% straight into the gross income of the estate as “ordinary income”. How can the executor reduce the tax impact of this income?
Administrative matters affecting tax effectiveness
Managing an estate with a view to minimizing income taxes on substantial retirement benefits is a game of chess. The executor must carefully time the receipt of the plan distributions (if the executor has the option) in order to reconcile this income with the deductions that the estate can take. The executor should hire an accountant who is an expert in fiduciary income taxes. This setting and the planning discussed here should begin sooner rather than later. If the executor waits for the retirement account to be paid off or for the estate’s income tax return to be filed, it is likely too late.
For a good introductory course in deductions that the Discount can cover for payments of expenses and distributions to beneficiaries, start with IRS Publication 559, Survivors, Executors, and Administrators. Then consider the following additional points:
- Fiscal year. The executor can choose a financial year (within limits). While required minimum distributions are always based on the calendar year, the rebate for these distributions may receive some tax deferral using a fiscal year. For example, if the estate’s fiscal year ends on March 31, a required minimum distribution for 2021 made in December 2021 will be included in the estate’s income for the year ended March 31, 2022. When this distribution has been distributed to the individual beneficiaries of the estate, it will be reported as received in 2022.
- 645 choice. If the testator had a revocable living trust, it may be beneficial to submit a section 645 election that the estate and trust are treated as a combined entity in administering the estate for income tax purposes. This choice allows the trust to use the estate’s fiscal year in administration. (Typically, trusts must use the calendar year for income tax filing purposes.)
- The IRD fume cupboard. Distributions from pension plans are subject to income tax for the recipient as “income from a testator” in accordance with Section 691 of the Tax Code. If the estate is large enough to be subject to federal estate tax, the federal estate tax paid on retirement benefits can be deducted for income tax when these benefits are paid out. This is known as an IRD fume cupboard. For example, if a $ 1 million IRA is included in the estate for estate tax purposes, the estate as a beneficiary of the IRA could have up to 400,000 IRD deduction to offset the $ 1 million revenue incurred at the payout of the IRA can be achieved through the estate. The deduction as a percentage of the total IRA value is greatest at the time of death (assuming the IRA continues to grow after that date).
- Choose. Certain expenses paid by the estate may be deducted on either the estate tax return or the estate income tax return. Some expenses may be deducted on the final income tax return of the testator rather than the estate return. Retirement benefits should be taken into account when deciding when and where to pay these deductions.
Distributions to generate income
Most practitioners understand that a distribution of an estate to an estate beneficiary will generally “carry out” an equivalent amount of the estate’s “net distributable income”. The estate may deduct this distribution (DNI deduction), and the beneficiary must then pay tax on the income paid to him. Since the estate is practically always in the highest tax bracket, the executor will look for ways to reduce the income tax burden on retirement benefits by distributing this income to the beneficiaries if they are in a lower tax bracket than the estate. The executor may even want to direct taxable income to certain beneficiaries who are in lower tax brackets than other beneficiaries … using other less taxable assets to fund each beneficiary’s shares.
These are important goals and strategies, but implementation is not easy: even if the strategies are permissible under the relevant instrument, the executor should not believe that he can reduce the income tax impact of pension plan distributions at any time by simply making a distribution to the beneficiaries. Here are four obstacles you don’t want to know about after you’ve already withdrawn the payout from your retirement account (and at number five, a way to bypass two of them):
- Can the executor make the distribution at this time? Under the laws of some state, distributions to beneficiaries cannot be made until after a period has elapsed for creditors to submit their claims or until tax liens have been settled. Sometimes a will dispute results in estate distributions being frozen by a court.
- Legacies. There is generally no DNI deduction for paying a “monetary” (fixed dollar amount) legacy. The will says, “Pay Jimmy $ 100,000 on my death.” The executor takes $ 100,000 from the IRA and pays it to Jimmy. This distribution is not deductible as it is a legacy of assets. The estate (not Jimmy) will be charged income tax on the IRA distribution.
- Separate share rule. If there are multiple remaining beneficiaries (as in “Pay the rest of my estate in equal parts to my children A, B, and C”), any retirement benefit distribution received from the estate will generally be prorated among their shares for DNI purposes. Suppose the executor pays all of the IRA money to child A (since A is in a low tax bracket) and distributes other assets of equal value to B and C. Unless the will requires that A’s portion be financed by the IRA If the DNI is generated by the estate, the IRA proceeds are received proportionally to all three children. Due to the separate share rule, the shares of B and C are each charged with a third of the income tax liability on the IRA distribution, even though only child A actually received IRA proceeds from the estate. Can the executor circumvent the “separate share rule”? See number five below.
- No DNI deduction for charity. There is no DNI deduction for payments to charity. Any distribution of the estate to a charity is only deductible, if at all, under the more stringent charity fiduciary withholding requirements (Tax Act Section 642 (c)). If the will stipulates that the charity’s portion must be funded from retirement benefits, this could make distribution tax deductible; Otherwise, the only way to avoid the non-DNI deduction rule for charitable distributions is to follow number five below.
- Submit the plan yourself, not the distribution. An IRA payable to the estate can be transferred intact from the estate to one or more remaining beneficiaries of the estate. Such transfers are permitted by Tax ID and by many, but not all, IRA providers. When an IRA is transferred to a remaining beneficiary, the transfer does not generate income for the estate, nor does it provide “DNI” to the beneficiary. The beneficiary simply takes over the inherited account as part of their inheritance. This step can help the executor avoid the “segregated share rule” (see number three above) and the limits of fiduciary income tax deduction (see number four). This type of transfer is likely not available for non-IRA retirement accounts.
Have we covered all possible income tax considerations? Probably not, but this is a good start!