Qualified Plans and Estate Taxes

It is vital that you coordinate your retirement with various estate planning issues. Generally speaking, whether property is transferred by court order or automatically, property in which the deceased (a.k.a. decedent) had an interest at the time of death is includible in the deceased's gross estate for estate tax purposes to the extent of the value of the deceased's interest in such property. This includes interests in qualified retirement plans. However, laws in community property states, limit the extent of a person's interest in community property to one-half of the value of the property.

The community property system is a holdover from French and Spanish laws that once controlled certain areas of the United States. Under this system, all property acquired during the marriage relationship (except such property as is separately received by gift, bequest, or devise) is regarded as the common possession, or product of the reciprocal labor, of the husband and wife. Under modern community property statutes, spouses generally have equal rights with respect to management of the community property. Upon the death of one spouse, the survivor is deemed to take his or her half of the community property not as heir of the deceased spouse but by virtue of the marriage relationship.

This means that a nonparticipating (surviving) spouse may be treated as having a vested community property interest in the deceased spouse's qualified plan, IRA, or simplified employee pension (SEP) plan. The community property system currently prevails in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington.

Hopefully, Uncle Sam will not get too much of your estate via estate taxes on amounts that aren't exempted. If you it looks like your assets will exceed estate tax exemption amounts, consult with an estate tax attorney or otherwise investigate potential ways to reduce your estate tax liability.

Tip The most common way to avoid estate taxes is to double your exemption amount through the unlimited marital deduction. This deduction allows any excess over to the deceased spouse's exemption amount to be taken out of the surviving spouse's exemption amount.

Income taxes. While you are cashing in your good deed chips in that great casino in the sky, most of your assets are being cashed in, so to speak, so that the IRS can finally collect some tax on the deceased's deferred income or assets that have increased in value. In technical tax terms, this is referred to as income in respect of decedent (IRD).

Generally, IRD is either taxable to the estate, in which case the estate pays income taxes from the estate's assets, or to the person who acquires the assets, whether directly or by exercising a right granted by bequest or inheritance. For example, a child who is a named beneficiary of a parent's qualified retirement plan must pay taxes that would be due on plan assets at the time of the parent's death.

Tip The surviving spouse of a deceased participant in a qualified retirement plan, such as a 401(k), is entitled to make a tax-free rollover of an eligible distribution from the plan to another qualified plan, a 403(b) annuity, or a 457 government plan the surviving spouse participates in, as well as to an IRA.