We know that Annuities, IRAs and Qualified plans are tax deferred. When the owner dies, the income tax liability passes to the beneficiaries. The beneficiaries must pay income tax as they take possession of the assets.

An account held by the beneficiary after the owner dies entails:

Basis dollars: (not typical on traditional IRAs and Qualified plans).

Earning during the owners life: (a.k.a Income in Respect of Decedent (IRD)).

Earnings after the owner dies.

The income that is accrued before the owners death is not the tax responsibility of the beneficiaries and is called IRD. At the owners death the entire value of the basis and earnings is included in the taxable estate. Beneficiaries must pay estate taxes on assets as well as income taxes when the funds are distributed.

As a beneficiary, one may be eligible for a tax deduction when taking a distribution and reporting the IRD. This deduction will help to offset any estate taxes that were due on the IRD when the owner dies. This reduces the double tax.

Example: Suppose a mother dies owning a $500,000 IRA, composed entirely of deductible contributions and earnings (and its her only IRD). Her total taxable estate is $4,000,000. This $500,000 IRA is included in her taxable estate and subject to estate tax. Then, as the IRA payments are distributed to her son (the beneficiary) over time, he must include the distribution in his taxable income. So he bears the burden of two taxes on this income -- the estate tax followed by the income tax. The son is estate taxed on the income tax liability.

In order to provide some relief from this double-tax on IRD, he is allowed to take an income tax deduction for the estate tax attributable to the IRD. He reports this deduction on his 1040 for the years he takes distributions from the IRA. The deduction can significantly reduce his income tax on the IRA distributions.

The beneficiary uses a 2-step process to figure out the IRD deduction for his 1040. First, he figures out what the total deduction is by calculating the estate tax the deceased had to pay on the IRD. Second, he figures out what part of this deduction he can use in any year that he takes a distribution from the IRD account.

The point: the beneficiary's income tax on the IRA distribution may not be as high as you think if the owner had to pay estate tax on the IRA. The client should ask his attorney or accountant for help in figuring the IRD deduction.

The income tax deduction is figured only for estate taxes actually paid on the IRA. If some of the IRA or annuity went to a spouse beneficiary under the marital deduction, that amount was not subject to the estate tax because of the martial deduction. Since no estate tax was paid, the spouse would not get an offsetting income tax deduction. Similarly, there will not be an IRD deduction if the owner's taxable estate less than $1,000,000 (in 2002), because no estate taxes will be due. The unified credit offsets the tax.