When an estate is involved, there can be some complicated tax implications. The Internal Revenue Service (IRS) has many rules regarding the handling of a decedent's estate. At the time of death, the assets of a decedent automatically are placed into the decedent's estate regardless of whether or not there is a will. This estate will exist until all assets are distributed and all matters are settled.
Read More: What Constitutes Estate Assets?
Tax Forms for an Estate
Form 1041 is known as the fiduciary return. This is the IRS income tax return for estates and trusts with gross annual income over $600. The executor of an estate must file this form each year using the estate's EIN until the estate assets are fully distributed. Income from the decedent's assets and any income that was not received prior to death will go on Form 1041.
Determining which assets must go on Form 1041 requires categorizing them as probate or non-probate assets. It is advisable to file a final 1040 on behalf of the decedent to inform the IRS of the death. Some estates will also require the filing of Form 706.
Retirement accounts with no named beneficiary or with the estate named as beneficiary will be considered probate and must be included on the 1041. IRAs with named beneficiaries other than the estate are non-probate and bypass the estate directly to the beneficiary; this is the simpler option. However, sometimes a trust is the better choice as a beneficiary.
Read More: How to Become an Administrator of Someone's Estate
Estate as the IRA Beneficiary
Generally, it is not necessary to include an IRA in an estate because the account will allow for the direct designation of beneficiaries. If a spouse inherits the IRA, they may treat it as their own, per IRS guidelines. This means any required minimum distributions will be based on the spouse's life and it can be rolled into their own IRA to continue growing tax-deferred.
The SECURE Act changed the guidelines for non-spouse IRA beneficiaries after 2019. Non-spouse beneficiaries cannot treat an inherited IRA as their own. In most cases, the non-spouse beneficiary must distribute the IRA within 10 years.
Serious consideration should be given before naming an estate as the beneficiary (or not identifying any beneficiary) of an IRA. Including the IRA in an estate may expose IRA assets to creditors. Alternately, an IRA distributed to an estate might require the immediate and full liquidation of the IRA, which will be immediately taxable.
Funds distributed to an estate from an IRA are subject to the estate tax, which is far higher than the income tax rate a direct beneficiary would pay on a distribution. However, if the IRA is intended to be donated to charity, then it might make sense to include the IRA as part of an estate. Donating an IRA to charity through a will or estate plan can substantially offset tax liabilities.
Read More: How to Dispose of an Estate
Taxes on IRA Estate Distributions
Yes, any IRA distributions to an estate are taxable in the year received and will be reported on Form 1041. An IRA with no beneficiary or with an estate designated as the beneficiary must be distributed within five years after death. Distributions are taxed as income rather than capital gains.
IRA assets are considered to be Income in Respect of the Decedent (IRD) and can be fully taxed in the year of death. The gross estate will establish estate tax including all IRD, though there is a deduction available for IRD. It is important to note that IRDs receive no step-up in basis; unlike other assets, IRAs receive no adjustment to basis. A possible option to reduce the tax liability for heirs is to convert the IRA into a Roth IRA.
Read More: The Pros & Cons of Estate Tax
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation. <!--StartFragment--><!--EndFragment-->