A charitable strategy to cut or avoid
those disrespectful after-death taxes
By Cora M. Barnhart • Bankrate.com

You've heard that death and taxes are inevitable. Some after-death taxes, though, can be cut or avoided.

Get ready for some alphabet soup: The IRS goes hard after IRD, especially that from IRAs. Translation: The Internal Revenue Service goes hard after certain income, earned in a person's life and passed on after death.

That income is called "Income in Respect of a Decedent" -- IRD. A typical type of IRD is in the form of an Individual Retirement Account. Income and estate taxes can be charged. In some particularly unfortunate cases, the income receives an additional pounding by a generation-skipping transfer tax as well.

What's an IRD, exactly?
IRD includes any income an individual is entitled to but doesn't receive over his lifetime. As the IRS defines it, "All gross income that the decedent would have received had death not occurred and that was not properly includible on the final return is income in respect of the decedent."

That includes IRAs, employee benefit plan distributions and U.S. Savings Bonds.

Other types of income vulnerable to this treatment are those that are earned during one's lifetime but not paid out until after the death. These can include salary, bonuses and stock dividends. Renewal commissions earned by a life insurance agent and fees due to doctors, lawyers and other professionals are also examples of this type of income.

I didn't think it could happen to me
Most taxpayers realize their estates will have to shell out federal estate taxes and sometimes state death tax on the money they pass on. But whoever receives that income will also pay federal and maybe state income tax on it.

Surviving spouses receiving an IRA or other type of IRD asset are often eligible for the estate tax marital deduction. The income tax on the proceeds still slams them, though. And leaving IRD property to grandchildren, grandnieces and/or grandnephews can mean shelling out even more to the IRS. Wealthy estates usually are slammed by a generation-skipping tax.

Plan now to help your heirs
A taxpayer doing estate-planning can minimize vulnerability to IRD taxes.

Someone planning to leave part of an estate to a favorite charity, for instance, should use IRD assets to make the gift. Then arrange to leave non-IRD assets to other beneficiaries.

Suppose a taxpayer has an estate that will be taxed at the top 55 percent rate. She has a $250,000 IRA and $250,000 in appreciated stock. She intends to leave $250,000 to her nephew and $250,000 to a favorite charity.

She decides to leave the IRA to her nephew and the stock to her favorite tax-exempt charity. The IRA will be slammed by both estate and income taxes. No tax will be payable on the stock.

One small change can make a big difference
Now see how making a slight switch affects the tax picture. Suppose she leaves the stock to her nephew and the IRA to the charity. The nephew still has to deal with an estate tax on the stock he receives. However, an income tax won't nail him. Plus, this action "steps up" his basis. This is what the IRS will perceive as his purchase price. A "stepped-up" basis will either reduce or eliminate capital gains when he later sells the stock.

The IRS won't tax the IRA due to the estate tax charitable deduction. And, provided the charity is tax-exempt, won't pay income tax on the gift.

If the nephew is a grandnephew, this strategy could be even more beneficial. Leaving him the IRA could subject the income to a generation-skipping tax. Leaving the IRA to charity also insulates the income from this tax.

The bottom line? Leave stock and other assets to family members and IRD assets to a tax-exempt charity.

-- Posted May 25, 2000