When a loved one passes away, it can be an emotional experience. Unfortunately, handling the deceased’s finances can add to this stress. While most people know that you need to file a final tax return for the deceased, most people don’t know how to handle income received after the person has died. This income is known as “income in respect of a decedent” (IRD), and it has its own special rules. Consider working with a financial advisor as you prepare an estate plan or implement a loved one’s estate plan.
What Is Income in Respect of a Decedent?
Income in respect of a decedent (IRD) is the income received after someone dies but not included in the person’s final tax return. When beneficiaries take over a deceased person’s finances, the situation can be complicated. This is especially true if they owned a business, had many types of bank and investment accounts, or were unorganized.
Examples of IRD include:
Uncollected salary, wages, bonuses, commissions and vacation or sick pay
Distributions from deferred compensation
Taxable distributions from retirement accounts
Interest on bank accounts
Dividends and capital gains from investments
Accounts receivable paid to a small business owned by the decedent (cash-basis only)
This is a good reminder that people should have a detailed list of financial accounts and investments for beneficiaries to refer to. This will give them a to-do list to notify them of your death and to avoid any accounts getting lost in the shuffle.
How Is IRD Taxed?
IRD is income that would have been included in the deceased’s tax returns had they not passed away. If this income was not included in the final tax return, then it is considered IRD. Where IRD is reported depends on who received the income. If paid to the estate, it should be included on the fiduciary return. When IRD is paid directly to a beneficiary, then the beneficiary should include it in their tax return.
If estate taxes are paid on the IRD received, tax law allows for an income tax deduction for estate taxes paid on that income. For beneficiaries that missed the IRD estate tax deduction, you may be able to amend tax returns to claim it.
Impact of IRD on Retirement Accounts
Retirement accounts can also be affected by IRD. As investors get older, they have to start taking required minimum distributions (RMDs) from Traditional IRAs, 401(k)s, and other taxable retirement accounts. Beneficiaries of these accounts have to follow distribution rules and make mandatory distributions as well.
RMDs for the year that the deceased pass away are considered part of their estate. When the value of a deceased person’s estate exceeds $11.7 million (2021 limits), the potential estate taxes can be significant.
The combination of estate taxes and income taxes on taxable retirement accounts can greatly reduce the value of an inheritance. Tax law allows for the deduction of estate taxes related to amounts reported as IRD to reduce the impact of this double taxation.
The Bottom Line
IRD can quickly complicate finances for the estate and beneficiaries of the deceased. There are potential opportunities for tax savings, but the rules can be hard to understand even for the most financially adept people. For this reason, it helps to involve a financial advisor and tax professional to ensure that you are not missing any income or assets and that your tax bill is not any higher than it should be.
Tips on Estate Planning
Knowing how to apply IRD to the estate of a deceased person can be a challenge. It is hard to concentrate on uncommon rules and situations when you’re already distracted by the emotional impact of the loss of a loved one. Having a trusted financial advisor guide you through this difficult time can help track down accounts and avoid missed opportunities for tax savings. Finding a financial advisor doesn’t have to be hard. The SmartAsset financial advisor matching tool can quickly match you with several advisors in your local area. If you’re ready, get started now.
Our tax return calculator factors in your location, marital status, income and dependents. It allows you to estimate the effect on your taxes owed based on changes to your income, dependents, and federal withholding.
Photo credit: ©iStock.com/m44, ©iStock.com/StefaNikolic, ©iStock.com/DGLimages