Decedent’s Deferred Retirement Accounts: Who Really Gets the Dollars?

By Frank Minuti, CPA

When an unmarried taxpayer passes away his or her deferred retirement account (DRA) passes to the named beneficiary(s). On the surface this sounds great. For example your single parent passes away and you inherit his/ her DRA valued at $1,000,000.

If this occurred in 2009 and your parent’s gross estate was valued at less than $3,500,000 there would not be any federal inheritance tax as the federal estate tax is only assessed on amounts in excess of $3,500,000.

If the death occurs in 2010 there would not be any federal inheritance tax as there is no federal estate tax for decedents passing away in 2010.

For decedents passing away in 2011 or later the federal inheritance tax rate will start at 41% on amounts over $1,000,000 and increase to 55% on all amounts in excess of $3,000,000. If a single decedent has $1,000,000 of real estate and other assets plus $1,000,000 of DRA dollars than the decedent’s estate is subject to $435,000 of estate tax. Payment of the tax reduces the net assets of the decedent passing to the heirs from $2,000,000 to $1,565,000.

Whether the decedent passed away in 2009, 2010 or 2011 the deferred retirement dollars are subject to federal and state income taxes. In California the combined federal and California income taxes on the $1,000,000 of deferred retirement dollars in 2011 could be as much as 48% or $480,000. This amount could be even greater if tax rates are increased in 2011 or beyond.

For deaths occurring in 2011 and later the federal inheritance tax of $435,000 combined with federal and state income taxes of as much as $480,000 could total $915,000. This means that of the $1,000,000 of deferred retirement plan dollars left to beneficiary(s) approximately $915,000 could go to the federal and California governments.

Beneficiaries are allowed to deduct as an itemized deduction on their federal tax return the estate tax paid on DRA ratably as the funds are received. This deduction could reduce but not eliminate the income taxes the beneficiary(s) pays.

The return of the federal inheritance tax for estates in excess of $1,000,000 beginning in 2011 makes estate tax planning very important for all taxpayers and especially so for those with assets in excess of $1,000,000 whether or not the estate includes deferred retirement accounts.