Estate Planning: Tax Deductions Sometimes Get Lost

As you think about your estate and the assets that your heirs will inherit, it is very important to understand that different items will be taxed differently after they are inherited. One of our jobs at BWFA is to help you make decisions that minimize your taxes while ensuring that inheritances reflect your intentions.

There are a number of deduction and income items that are passed from an estate to your beneficiaries, including: capital losses, charitable contributions, estate taxes, and various types of investment income.

Usually, the solution is fairly easy. Capital losses that the estate could not use can be passed through to beneficiaries after the estate is closed. These capital losses can be used by heirs (the beneficiaries) to offset other capital gains or ordinary income on their tax returns.

Your estate also might contain income that was due to you prior to your passing but had not yet been paid. This is known as “Income in Respect of a Decedent,” or IRD. Beneficiaries can take a tax deduction for the portion of estate taxes paid on IRD money.

Let’s use an example to see how this works. At the time of Bill’s passing, he owned real estate and an Individual Retirement Account (IRA). Because the IRA represented income that Bill could have received, but had not, the IRA becomes IRD. In the table below, we see that Bill’s estate had to pay estate taxes of $230,000. When Jane, Bill’s beneficiary, takes her $10,000 required minimum distribution (RMD) from the IRA (now called a beneficiary IRA), she will get a deduction for some of the estate taxes paid on the IRD.

 

Example of Tax Deduction for estate taxes paid on IRAs
If Jane, Bill’s beneficiary, makes a $10,000 distribution from the IRA all of which represents Income in Respect of Decendent (IRD) Jane will get a $4,600 itemized deduction on her personal tax return.
Estate is comprised of:
   Real estate all titled in Bill’s name2,000,000
   IRA owned by Bill500,000
Total Estate Value2,500,000
Step 1 Calculate Estate’s net Income in Respect of Decedent (IRD)
   IRD included in gross estate500,000
   Less deductions allowable to IRD0
Net IRD500,000
Step 2 Calculate estate tax with and
without the IRD
Total
Estate
Estate
without IRD
   Gross estate2,500,0002,000,000
   Minus deductions, taxable gifts00
Taxable estate (calculated on $2.5 MM)2,500,0000
Estate Tax1,010,8000
   Less unified credit (based on $2 MM exemption amount)(780,800)0
Net Estate Tax230,0000
Step 3 Calculate estate tax attributable to IRD
   Tax on estate230,000
   Tax on estate without IRD0
Reduction to estate tax due to IRD230,000
Step 4 Calculate Jane’s itemized deduction due to estate taxes already paid on IRA
   Divide current year’s IRD/Total IRD x Estate Taxes on IRD
   Assume $10,000 IRD distribution from IRA
   =10,000 / 500,000 * 230,000
Deduction on Jane’s personal tax return4,600
Beneficiaries will be entitled to a deduction each time they withdraw funds from the IRA.

 

This example shows how estate tax issues can pass through to the beneficiaries of the estate.

Staying on top of these issues is not always easy. That’s why BWFA recommends consolidating your financial affairs with one, full-service advisor; this will ensure that estate tax information is not lost.

BWFA also recommends that clients have a Family Summit to identify possible tax obligations that your estate might generate. The Family Summit can help you and your beneficiaries prepare for a smoother transition, and it can be the perfect opportunity to raise numerous other issues about inheritance and legacy.

Contact us for more information about Family Summits.