Individual Tax briefs
Watch out for “income in respect of a decedent” issues when receiving an inheritance
Most people are genuinely appreciative of inheritances, and who wouldn’t enjoy some unexpected money? But in some cases, it may turn out to be too good to be true. While most inherited property is tax-free to the recipient, this isn’t always the case with property that’s considered income in respect of a decedent (IRD). If you have large balances in an IRA or other retirement account — or inherit such assets — IRD may be a significant estate planning issue.
How it works
IRD is income that the deceased was entitled to, but hadn’t yet received, at the time of his or her death. It’s included in the deceased’s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death.
To ensure that this income doesn’t escape taxation, the tax code provides for it to be taxed when it’s distributed to the deceased’s beneficiaries. Also, IRD retains the character it would have had in the deceased’s hands. For example, if the income would have been a long-term capital gain to the deceased, such as uncollected payments on an installment note, it’s taxed as such to the beneficiary.
IRD can come from various sources, including unpaid salary, fees, commissions or bonuses, and distributions from traditional IRAs and employer-provided retirement plans. In addition, IRD results from deferred compensation benefits and accrued but unpaid interest, dividends and rent.
The lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value.
What recipients can do
Although IRD must be included in the income of the recipient, a deduction may come along with it. The deduction is allowed (as an itemized deduction) to lessen the “double tax” impact that’s caused by having the IRD items subject to the decedent’s estate tax as well as the recipient’s income tax.
To calculate the IRD deduction, the decedent’s executor may have to be contacted for information. The deduction is determined as follows:
- First, you must take the “net value” of all IRD items included in the decedent’s estate. The net value is the total value of the IRD items in the estate, reduced by any deductions in respect of the decedent. These are items which are the converse of IRD: items the decedent would have deducted on the final income tax return, but for death’s intervening.
- Next you determine how much of the federal estate tax was due to this net IRD by calculating what the estate tax bill would have been without it. Your deduction is then the percentage of the tax that your portion of the IRD items represents.
Calculating the deduction can be complex, especially when there are multiple IRD assets and beneficiaries.
Be prepared
As you can see, IRD assets can result in an unpleasant tax surprise. Because these assets are treated differently from other assets for estate planning purposes, contact us. Together we can identify IRD assets and determine their tax implications.
Keep these 3 issues in mind after you file your return
The tax filing deadline for 2023 tax returns is April 15 this year. If you need more time, you can file for an extension until October 15. In either case, once your 2023 tax return has been successfully filed with the IRS, there may still be some issues to bear in mind. Here are three considerations.
1. Waiting for your refund? You can check on it
The IRS has an online tool that can tell you the status of your refund. Go to irs.gov and click on “Get your refund status” to find out about yours. You’ll need your Social Security number or Individual Taxpayer Identification Number, filing status, and the exact refund amount.
2. Throwing away tax records
You should hold on to tax records related to your return for as long as the IRS can audit your return or assess additional taxes. The statute of limitations is generally three years after you file your return.
However, the statute of limitations extends to six years for taxpayers who understate their gross income by more than 25%.
You should keep certain tax-related records longer. For example, keep your actual tax returns indefinitely, so you can prove to the IRS that you filed a legitimate return. (There’s no statute of limitations for an audit if you didn’t file a return or you filed a fraudulent one.)
What about your retirement account paperwork? Keep records associated with a retirement account until you’ve depleted the account and reported the last withdrawal on your tax return, plus three (or six) years. And retain records related to real estate or investments for as long as you own the asset, plus at least three years after you sell it and report the sale on your tax return. (You can keep these records for six years if you want to be extra safe.)
3. Filing an amended return if you failed to report something
In general, you can file an amended tax return on Form 1040-X and claim a refund within three years after the date you filed your original return or within two years of the date you paid the tax, whichever is later. So for a 2023 tax return that you file on April 15, 2024, you can generally file an amended return until April 15, 2027.
However, there are a few opportunities when you have longer to file an amended return. For example, the statute of limitations for bad debts is longer than the usual three-year time limit for most items on your tax return. In general, you can amend your tax return to claim a bad debt for seven years from the due date of the tax return for the year that the debt became worthless.
We’re here all year
Contact us if you have questions about tax record retention, your refund or filing an amended return. We’re not just available at tax filing time. You can reach us year-round.
The tax deadline is almost here: File for an extension if you’re not ready
The April 15 tax filing deadline is right around the corner. However, you might not be ready to file. Sometimes, it’s not possible to gather your tax information by the due date. If you need more time, you should file for an extension on Form 4868.
An extension will give you until October 15 to file and allows you to avoid “failure-to-file” penalties. However, it only provides extra time to file, not to pay. Whatever tax you estimate is owed must still be sent by April 15, or you’ll incur penalties — and as you’ll see below, they can be steep.
Two different penalties
Separate penalties apply for failing to pay and failing to file. The failure-to-pay penalty runs at 0.5% for each month (or part of a month) the payment is late. For example, if payment is due April 15 and is made May 25, the penalty is 1% (0.5% times 2 months or partial months). The maximum penalty is 25%.
The failure-to-pay penalty is based on the amount shown as due on the return (less amounts paid through withholding or estimated payments), even if the actual tax bill turns out to be higher. On the other hand, if the actual tax bill turns out to be less, the penalty is based on the lower amount.
The failure-to-file penalty runs at the more severe rate of 5% per month (or partial month) of lateness to a maximum 25%. If you file for an extension on Form 4868, you’re not filing late unless you miss the extended due date. However, as mentioned earlier, a filing extension doesn’t apply to your responsibility for payment.
If the 0.5% failure-to-pay penalty and the failure-to-file penalty both apply, the failure-to-file penalty drops to 4.5% per month (or part) so the combined penalty is 5%. The maximum combined penalty for the first five months is 25%. Thereafter, the failure-to-pay penalty can continue at 0.5% per month for 45 more months (an additional 22.5%). Thus, the combined penalties can reach a total of 47.5% over time.
The failure-to-file penalty is also more severe because it’s based on the amount required to be shown on the return, and not just the amount shown as due. (Credit is given for amounts paid through withholding or estimated payments. If no amount is owed, there’s no penalty for late filing.) For example, if a return is filed three months late showing $5,000 owed (after payment credits), the combined penalties would be 15%, which equals $750. If the actual liability is later determined to be an additional $1,000, the failure-to-file penalty (4.5% × 3 = 13.5%) would also apply to this amount for an additional $135 in penalties.
A minimum failure-to-file penalty also applies if a return is filed more than 60 days late. This minimum penalty is the lesser of $485 (for returns due after December 31, 2023) or the amount of tax required to be shown on the return.
Exemption in certain cases
Both penalties may be excused by the IRS if lateness is due to “reasonable cause” such as death or serious illness in the immediate family.
Interest is assessed at a fluctuating rate announced by the government apart from and in addition to the above penalties. Furthermore, in particularly abusive situations involving a fraudulent failure to file, the late filing penalty can jump to 15% per month, with a 75% maximum.
If you have questions about filing Form 4868 or IRS penalties, contact us.
Update on retirement account required minimum distributions
If you have a tax-favored retirement account, including a traditional IRA, you’ll become exposed to the federal income tax required minimum distribution (RMD) rules after reaching a certain age. If you inherit a tax-favored retirement account, including a traditional or Roth IRA, you’ll also have to deal with these rules.
Specifically, you’ll have to: 1) take annual withdrawals from the accounts and pay the resulting income tax and/or 2) reduce the balance in your inherited Roth IRA sooner than you might like.
Let’s take a look at the current rules after some recent tax-law changes.
RMD basics
The RMD rules require affected individuals to take annual withdrawals from tax-favored accounts. Except for RMDs that meet the definition of tax-free Roth IRA distributions, RMDs will generally trigger a federal income tax bill (and maybe a state tax bill).
Under a favorable exception, when you’re the original account owner of a Roth IRA, you’re exempt from the RMD rules during your lifetime. But if you inherit a Roth IRA, the RMD rules for inherited IRAs come into play.
A later starting age
The SECURE 2.0 law was enacted in 2022. Previously, you generally had to start taking RMDs for the calendar year during which you turned age 72. However, you could decide to take your initial RMD until April 1 of the year after the year you turned 72.
SECURE 2.0 raised the starting age for RMDs to 73 for account owners who turn age 72 in 2023 to 2032. So, if you attained age 72 in 2023, you’ll reach age 73 in 2024, and your initial RMD will be for calendar 2024. You must take that initial RMD by April 1, 2025, or face a penalty for failure to follow the RMD rules. The tax-smart strategy is to take your initial RMD, which will be for calendar year 2024, before the end of 2024 instead of in 2025 (by the April 1, 2025, absolute deadline). Then, take your second RMD, which will be for calendar year 2025, by Dec. 31, 2025. That way, you avoid having to take two RMDs in 2025 with the resulting double tax hit in that year.
A reduced penalty
If you don’t withdraw at least the RMD amount for the year, the IRS can assess an expensive penalty on the shortfall. Before SECURE 2.0, if you failed to take your RMD for the calendar year in question, the IRS could impose a 50% penalty on the shortfall. SECURE 2.0 reduced the penalty from 50% to 25%, or 10% if you withdraw the shortfall within a “correction window.”
Controversial 10-year liquidation rule
A change included in the original SECURE Act (which became law in 2019) requires most non-spouse IRA and retirement plan account beneficiaries to empty inherited accounts within 10 years after the account owner’s death. If they don’t, they face the penalty for failure to comply with the RMD rules.
According to IRS proposed regulations issued in 2022, beneficiaries who are subject to the original SECURE Act’s 10-year account liquidation rule must take annual RMDs, calculated in the usual fashion — with the resulting income tax. Then, the inherited account must be emptied at the end of the 10-year period. According to this interpretation, you can’t simply wait 10 years and then drain the inherited account.
The IRS position on having to take annual RMDs during the 10-year period is debatable. Therefore, in Notice 2023-54, the IRS stated that the penalty for failure to follow the RMD rules wouldn’t be assessed against beneficiaries who are subject to the 10-year rule who didn’t take RMDs in 2023. It also stated that IRS intends to issue new final RMD regulations that won’t take effect until sometime in 2024 at the earliest.
Contact us about your situation
SECURE 2.0 includes some good RMD news. The original SECURE Act contained some bad RMD news for certain account beneficiaries in the form of the 10-year account liquidation rule. However, exactly how that rule is supposed to work is still TBD. Stay tuned for developments.
Beware of a stealth tax on Social Security benefits
Some people mistakenly believe that Social Security benefits are always free from federal income tax. Unfortunately, that’s often not the case. In fact, depending on how much overall income you have, up to 85% of your benefits could be hit with federal income tax.
While the truth about the federal income tax bite on Social Security benefits may be painful, it’s better to understand it. Here are the rules.
Calculate provisional income
The amount of Social Security benefits that must be reported as taxable income on your tax return depends on your “provisional income.” To arrive at provisional income, start with your adjusted gross income (AGI), which is the number that appears on Page 1, Line 11 of Form 1040. Then, subtract your Social Security benefits to arrive at your adjusted AGI for this purpose.
Next, take that adjusted AGI number and add the following:
- 50% of Social Security benefits,
- Any tax-free municipal bond interest income,
- Any tax-free interest on U.S. Savings Bonds used to pay college expenses,
- Any tax-free adoption assistance payments from your employer,
- Any deduction for student loan interest, and
- Any tax-free foreign earned income and housing allowances, and certain tax-free income from Puerto Rico or U.S. possessions.
The result is your provisional income.
Find your tax scenario
Once you know your provisional income, you can determine which of the following three scenarios you fall under.
Scenario 1: All benefits are tax-free
If your provisional income is $32,000 or less, and you file a joint return with your spouse, your Social Security benefits will be federal-income-tax-free. But you might owe state income tax.
If your provisional income is $25,000 or less, and you don’t file jointly, the general rule is that Social Security benefits are totally federal-income-tax-free. However, if you’re married and file separately from your spouse who lived with you at any time during the year, you must report up to 85% of your Social Security benefits as income unless your provisional income is zero or a negative number, which is unlikely.
Having federal-income-tax-free benefits is nice, but, as you can see, this favorable outcome is only allowed when provisional income is quite low.
Scenario 2: Up to 50% of your benefits are taxed
If your provisional income is between $32,001 and $44,000, and you file jointly with your spouse, up to 50% of your Social Security benefits must be reported as income on Form 1040.
If your provisional income is between $25,001 and $34,000, and you don’t file a joint return, up to 50% of your benefits must be reported as income.
Scenario 3: Up to 85% of your benefits are taxed
If your provisional income is above $44,000, and you file jointly with your spouse, you must report up to 85% of your Social Security benefits as income on Form 1040.
If your provisional income is above $34,000, and you don’t file a joint return, the general rule is that you must report up to 85% of your Social Security benefits as income.
As mentioned earlier, you also must report up to 85% of your benefits if you’re married and file separately from your spouse who lived with you at any time during the year — unless your provisional income is zero or a negative number.
Turn to us
This is only a very simplified explanation of how Social Security benefits are taxed. With the necessary information, we can precisely calculate the federal income tax, if any, on your Social Security benefits.
A job loss is bad but the tax implications could make it worse
Unemployment has been holding steady recently at 3.7%. But there are still some people losing their jobs — particularly in certain industries including technology and media. If you’re laid off or terminated from employment, taxes are likely the last thing on your mind. However, there are tax implications due to your altered employment circumstances.
Depending on your situation, the tax aspects can be complex and require you to make decisions that may affect your tax bill for this year and for years to come. Be aware of these three areas.
1.Unemployment and payments from your former employer
Many people are surprised to find out that federal unemployment compensation is taxable. (Some states exempt unemployment comp from state tax.) In addition, payments from a former employer for any accumulated vacation or sick time are taxable. Although severance pay is also taxable and subject to federal income tax withholding, some elements of a severance package may get special treatment. For example:
- If you sell stock acquired by way of an incentive stock option (ISO), part or all of your gain may be taxed at lower long-term capital gain rates rather than at ordinary income tax rates, depending on whether you meet a special dual holding period.
- If you received — or will receive — what’s commonly referred to as a “golden parachute payment,” you may be subject to an excise tax equal to 20% of the portion of the payment that’s treated as an “excess parachute payment” under very complex rules, along with the excess parachute payment also being subject to ordinary income tax.
- The value of job placement assistance you receive from your former employer usually is tax-free. However, the assistance is taxable if you had a choice between receiving cash or outplacement help.
2.Health insurance costs
Under the COBRA rules, employers that offer group health coverage generally must provide continuation coverage to most terminated employees and their families. While the cost of COBRA coverage is usually expensive, the amount of any premium you pay for insurance that covers medical care is an eligible medical expense for tax purposes. That means it’s deductible if you itemize deductions and if your total medical expenses exceed 7.5% of your adjusted gross income.
If your former employer pays some of your medical coverage for a period of time after termination, you won’t be taxed on the value of the benefit.
3.Retirement plan balance
Employees whose employment is terminated may need tax planning help to determine the best option for amounts they’ve accumulated in retirement plans sponsored by former employers, such as a 401(k) plan. In many cases, a direct, tax-free rollover to an IRA is the best move. You may also choose to leave the account in your previous employer’s 401(k) plan (although the employer may elect to distribute the funds to you). Or, if you get a new job, you may want to transfer the money in the account with your former employer to your new employer’s 401(k) plan.
If you’re under age 59½, and make withdrawals from your former company’s plan or IRA to supplement missing income, you may owe an additional 10% penalty tax unless you qualify for an exception.
If a distribution from the retirement plan includes employer securities in a lump sum, the distribution is taxed under the lump-sum rules, except that “net unrealized appreciation” in the value of the stock isn’t taxed until the securities are sold or otherwise disposed of in a later transaction.
Further, any loans you’ve taken out from your former employer’s retirement plan, such as a 401(k)-plan loan, may be required to be repaid immediately, or within a specified period. If they aren’t, they may be treated as if the loan is in default. If the balance of the loan isn’t repaid within the required period, it will typically be treated as a taxable deemed distribution.
If you need assistance, contact us. We can help you navigate the best path forward during this transition period.
