What You Need to Know If You Inherit Income

Larry Villano, Publisher of Loopholelewy.com

Federal Estate Tax Deduction

If a person has a right to receive income but dies before receiving it, that income goes into the decedent's gross estate and is subject to estate tax.

What's more, this same income in respect of the decedent is also taxed when received by the recipient, such as the beneficiary. The good news is, an income tax deduction is allowed to the recipient for the estate tax paid on the income. The sad news is, many recipients are ignorant of this deduction and as a result, are overpaying income taxes.

In fact, I recently read that this deduction is unclaimed to the tune of about $3 trillion! This is very troubling.

If you inherit a traditional IRA, annuity, or other income in respect of a decedent (IRD) and must report income from your inheritance, you may be eligible for an itemized deduction for the portion of federal estate tax related to this property. This deduction is not subject to the 2% of adjusted gross income floor and there is no dollar limit on this deduction.

To claim this deduction, the IRA, annuity, or other income must have been part of an estate that was subject to federal estate taxes.

Examples of income in respect of a decedent (IRD) include:

  • Accounts payable to self-employed business owners on the cash basis
  • Benefits from 401(k) and other qualified retirement plans
  • Damage awards from lawsuits
  • Deferred compensation
  • Health Savings Accounts
  • Interest on U.S. savings bonds that has been deferred
  • Royalties
  • Survivor annuities
  • Traditional IRAs

If federal estate tax has already been paid on income in respect of a decedent, you figure the portion of the estate tax deductible in the current year. For example, if you withdraw all of the IRA funds, then all of the estate tax related to this asset is deductible this year.

What You Should Know

  • The deduction for estate tax paid can only be claimed for the same tax year in which the income in respect of a decedent must be included in the recipient's income.
  • Individuals can claim this deduction only as an itemized deduction on line 28 of Schedule A (Form 1040).
  • This deduction is not subject to the 2% limit on miscellaneous itemized deductions.
  • Estates can claim the deduction on line 19 of Form 1041.
  • For the alternative minimum tax computation, the deduction is not included as an itemized deduction that is an adjustment to taxable income.
  • If income in respect of a decedent is capital gain income, you must reduce the gain, but not below zero, by any deduction for estate tax paid on such gain. This applies in figuring the following:
    • The maximum tax on net capital gain (including qualified dividends)
    • The 50% exclusion for gain on small business stock
    • The limitation on capital losses
  • State estate or inheritance taxes are not deductible

For more on Survivors, Executors, and Administrators, see IRS publication 559.