Wills and Trusts

Wyatt, Tarrant & Combs, LLP


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SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III

SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III D

Traditional IRA and Qualified Retirement Assets

In 2013, Investment Company Institute estimated that total retirement assets were over $20 trillion (including government plans, private defined benefit plans, defined contribution plans and individual retirement accounts).[1]  Assets in IRAs and defined contribution plans totaled more than ½ of the total at approximately $11.1 trillion.  Although IRA and qualified retirement assets make up one of the largest asset types of assets owned by individuals, they are one of the most problematic from an estate planning perspective.

IRA and qualified retirement assets are not transferable during the lifetime of the owner,[2] so the assets are never candidates for lifetime gifts unless the owner is willing to incur a taxable distribution of the assets.  As such, to the extent not drawn-down prior to death, the assets are includible in the estate for transfer tax purposes,[3] and by definition, the assets will use some or all of the decedent’s Applicable Exclusion Amount, unless the assets to surviving spouse under the marital deduction under section 2056 of the Code or to a charitable organization under section 2055 of the Code.[4]  To make things worse, IRA and qualified retirement assets are considered income in respect (IRD) under section 691 of the Code.[5]   IRD assets are not entitled to a “step-up” in basis,[6] and all distributions (whether paid over time or not) to a beneficiary are taxable as ordinary income.[7]  Even though the beneficiary is entitled to an income tax deduction[8] (“IRD deduction”) for estate taxes payable by virtue of the inclusion of the assets, there is no Federal income tax deduction for state death taxes that might be payable, and given the reduced Federal transfer tax rate of 40% and the cost-of-living increase on the Applicable Exclusion Amount, many taxpayers will have very little or no IRD deduction to shelter the on-going ordinary income tax problem.

A distribution from a decedent’s IRA to a surviving spouse may be “rolled over” to another qualified retirement plan or IRA, thereby deferring the recognition of income.[9]  In addition, if the surviving spouse is the beneficiary of all or a portion of the decedent’s IRA, the surviving spouse may also elect to treat the decedent’s IRA as his or her own IRA.[10]  In both of the foregoing cases, the IRD problem discussed above continues after the death of the surviving spouse (unless the surviving spouse remarries).

Contrast the foregoing treatment with Roth individual retirement plans (“Roth IRAs”).[11]  Roth IRA assets are treated similarly to assets in a traditional IRA in that: (i) the account itself is not subject to income tax;[12] (ii) distributions to designated beneficiaries are subject to essentially the same required minimum distribution rules after the death of the original Roth IRA owner;[13] and (iii) surviving spouses may treat a Roth IRA as his or her own and from that date forward the Roth IRA will be treated as if it were established for the benefit of the surviving spouse.[14]  In contrast to a traditional IRA, distributions to a qualified beneficiary are not taxable to the beneficiary,[15] and as discussed above, are not subject to the Medicare tax.[16]  The overall result for decedents with Roth IRA assets, the qualified beneficiaries of the Roth IRA effectively receive the benefit of a “step-up” in basis.  Since 2010,[17] all taxpayers regardless of adjusted gross income[18] could convert traditional IRA assets into a Roth IRA.  The conversion is considered a taxable event causing the converted amount to be includible in gross income and taxable at ordinary income tax rates.[19]  Direct taxable rollovers from qualified company-based retirement accounts (section 401(k), profit sharing, 403(b), and section 457 plans) into a Roth IRA.[20]  Individuals who have excess qualified retirement assets, have sufficient funds to pay the resulting tax liability from outside of the retirement account, and who are not planning to donate the asset to a charitable organization are great candidates to do a Roth IRA conversion.  Notwithstanding the clear benefits of passing the Roth IRA assets to children and grandchildren outside of the scope of the IRD provisions, not many individuals are willing to pay the income tax cost of the conversion.

Turney P. Berry

Louisville, Kentucky


[1] Investment Company Institute, Release: Quarterly Retirement Data, First Quarter 2013, http://www.ici.org/research/stats/retirement/ret_13_q1,  (03/31/201).

[2] See the anti-alienation provision in § 401(a)(13)(A).

[3] § 2039(a).

[4] The IRS has taken the position that qualified retirement assets used to fund a pecuniary bequest to a charitable organization will be considered an income recognition event, triggering ordinary income.  CCA 200644020.

[5] See e.g., Ballard v. Commissioner, T.C. Memo 1992-217, Hess v. Commissioner, 271 F.2d 104 (3d Cir. 1959), Rev. Rul. 92-47, 1992-1 C.B. 198, Rev. Rul. 69-297, 1969-1 C.B. 131, PLR 9132021, and GCM 39858 (9/9/91).

[6] § 1014(c).

[7] §§ 72, 402(a) and 408(d)(1), assuming the decedent owner had no nondeductible contributions.  See § 72(b)(1) and (e)(8).

[8] § 691(c)(1).

[9] § 402(c)(9).

[10] Treas. Reg. § 1.408-8, Q&A-5(a).

[11] § 408A.

[12] Treas. Reg. § 1.408A-1, Q&A-1(b).

[13] Treas. Reg. § 1.408A-6, Q&A-14.  One specific exception is the “at-least-as-rapidly” rule under § 401(a)(9)(B)(i).

[14] Treas. Reg. § 1.408A-2, Q&A-4.

[15] § 408A(d)(1).

[16] § 1411(c)(5).

[17] Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222, effective for tax years beginning after December 31, 2009.

[18] Prior to this change, only taxpayers having less than $100,000 in modified adjusted gross income could convert a Traditional IRA to a Roth IRA.  Former § 408A(c)(3)(B).

[19] § 408A(d)(3)(A)(i).

[20] See Notice 2008-30, 2008-12 I.R.B. 638 (3/24/2008) and Notice 2009-75, 2009-39 I.R.B. 436 (9/28/2009). § 408A(d)(3)(A).