Income in Respect of a Decedent (IRD)

Income in respect of a decedent (IRD) is untaxed income that a decedent earned, had a right to receive or was otherwise owed to a decedent at the time he or she died.

IRD is taxed to the estate, individual, beneficiary or entity that inherits the income, and is reported on a recipient's income tax return during the year it was received. The way IRD is reported for income tax returns typically depends upon whether it was paid to the decedent's estate, or paid directly to a beneficiary.

While there are many types of IRD, some of the most common examples include: retirement plan assets, IRA distributions, unpaid interest and dividends, salary, wages, and sales commissions.

Income in respect of a decedent is just any money that exists out in the world that is owed to someone after they pass away. This could be for any number of reasons. Maybe there are unpaid wages, dividends that needs to be collected, etc.

And while most understand a tax return must be filed on behalf of the decedent’s (a.k.a. deceased’s) estate, people are often surprised and stressed when they realize the complex nature of taxes on income called “income in respect of a decedent”, or IRD.

For example, retirement accounts like an IRA or 401K paid to a beneficiary mean the beneficiary has to pay taxes. 

And when a 401K participant dies, if there are outstanding loans, they must be paid back. This paying back triggers 401k distribution, which is a form of income, which therefore creates taxes.

So while when paying off loans you do have the option of sending money from another bucket like a bank CD (certificate of deposit) or other existing assets, many people when overwhelmed or in a hurry simply use internal funds of the 401K. 

That can seem like a good idea until you get your tax bill.

Examples of IRD include:

• Uncollected salary, wages, bonuses, commissions, and vacation or sick pay
• Bank account interest
• Retirement plans that are taxable, e.g. an IRA
• Deferred compensation distributions
• Dividends and capital gains from investments
• Stock options exercised
• Accounts receivable paid to a small business owned by the decedent (cash-basis only)

Important note: tax rates vary widely depending on what other income is in play for each of these examples. And if the deceased owned a business, then there’s even more complexity.

Say someone named Mary’s father passed away unexpectedly last year, and her mother had passed a decade ago with the majority of assets inside an Individual Retirement Account (IRA). 

Mary heard of friends who had situations where there were no taxes due on inherited estate (usually have no retirement funds), and presumed that will be true with her own parents' assets. Unfortunately, that’s not the case.

Yes, you get a deduction on federal taxes when you're working, and if your employer puts money into an IRA or other eligible retirement vehicle, they get a write off as well…

But! 

The thing is, all the money in the 401K/IRA/403B or other qualified retirement accounts are taxable on distribution. 

What often happens is IRA holders only take the least amount the government requires to take out and lets the account grow along with the tax liability. This is a smart move. 

So for Mary, she may be in peak earning years when she inherits the retirement account, and if she doesn’t handle distribution well, she may add unnecessary taxes and push herself into a higher tax bracket. 

Here is another overlooked pitfall of inherited IRA: Say Mary lives in a state where there is State Income tax rate as well as the federal, but her parents live in Florida where there are no income taxes. This can increase the tax burden.  

There are some practical ways to address this and also address the fact that Mary has to claim within ten years the max allowed by new rules under the SECURE ACT to stretch out payments.

The bottom line is that these are complicated tax considerations that are best solved by a professional, and oftentimes the money you save navigating taxes more intelligently more than makes up for the cost of their service. 

Note: For beneficiaries that missed the IRD estate tax deduction, you may be able to amend tax returns to claim it. 

Some advice on Required Minimum Distributions 

Currently those age 72 and older must take an increasing percentage of the previous year’s balance out of qualified funds like IRA, 401K, 403B etc. under the required minimum distribution rules. 

 In the year of the deceased’s death, the RMD (required minimum distributions) for that year is counted as part of the deceased’s final tax return.   

REQUIRED MINIMUM DISTRIBUTION according to IRS is the minimum amount you must withdraw from your account year. You generally have to start taking withdrawals from your IRS, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 72. ROTH IRAs do not require withdrawals until after the death of the owner.

Retirement plans have distribution rules, and getting clarity here is incredibly important for taxes. The timing of cash flows and how to best optimize assets based on your custom approach to final distributions is critical. 

In short, understanding the rules in play and how you can best reduce your tax burden instead of doing a bulk withdrawal can have a huge impact on the net results of your distribution and how much of your financial legacy is passed on to your heirs and beneficiaries.

Why being cautious is the smartest choice 

 For those of you who want to move quickly, I get it, but it can be hugely beneficial to withdraw slowly over time to minimize your tax burden.  

For example, I’ve seen families distribute ROTH IRA’s outright, even though there was a clear opportunity to let them grow another decade and then get all of those additional gains tax-free! That’s the power of knowing the law. 

I’ve also seen families take a full lump sum and create 20-50% more taxes for their money instead of taking more strategic withdrawals over the following years. There is no one “good way” to tackle this, either. Every financial situation brings its own unique nuance, and that’s why getting professional advice is so valuable and why you should be so wary of “free advice” when tackling such complex and impactful financial issues.  

Many insurance annuity salespeople and wealth management gurus who love to talk a big game and make it seem easy want to capture your newfound assets by giving generalized, free advice.  

Instead, consider hiring someone who can evaluate the bigger picture for a fee and give you unique and strategic advice.

Many people can’t afford to get these decisions wrong, so make sure you get the right advice from the right people. It may be one of the most important decisions you make.