Navigating the Estate-bequest Terrain

As a general rule, inherited assets are not subject to federal income tax. But if a beneficiary receives a gift before the death of the donor, it is considered “Income in Respect of a Decedent” and will be subject to income tax in the hands of that beneficiary.

There are many of these IRD assets: savings bonds, lottery winnings, IRAs, etc. Since these assets carry income tax burdens, they’re excellent candidates for charitable giving.

This especially is true for qualified-plan and IRA assets in light of the revised regulations issued recently by the Internal Revenue Service, which govern the computation of minimum-required distributions. Since 2001, the identity of the beneficiary of a qualified plan or IRA does not impact how much the participant or owner must take out of the account each year, e.g., the computation of the minimum-required distribution.

Qualified plans and IRAs
Because funds held in qualified plans and IRAs are subject to federal income tax when withdrawn by the beneficiary, they are better suited for charitable transfers at death, rather than doled out sporadically during the donor’s lifetime.

For example, a father has $50,000 in an IRA and $50,000 in low-basis appreciated securities. He intends to leave half his estate to his college, half to his son.

A smart college development officer will suggest that he execute a will, leaving his probate estate to his son, and designate his alma mater as a beneficiary of the IRA.

Assuming there is no change in value, both the college and son will receive $50,000. But the college will not be taxed on the IRD included in the IRA.

The son, on the other hand, will receive a “step-up” in basis for the securities he inherits and will not be taxed on the capital gained that otherwise would be attributed to the appreciation in value.