A Special Tax Deduction You Don't Want to Miss (!) and Finding a 529 Plan

Dear Readers,

There are lots of shortcuts in the vernacular of investing:  IRA, 401(k), IPO, S&P, to name a few.  Here's another to add to your "must-know" vocabulary: IRD.  The letters stand for "Income in Respect of a Decedent."

Hang in there with me. You know I'll do my best to explain this is everyday language and the consequence of not being aware of this are drastic: it amount paying taxes TWICE on the same asset! (Have I got your attention now?)

In a nutshell, IRD is income that a deceased person was entitled to receive had he/she lived.  This could be as simple as the owner of a business receiving payment after death for services rendered while alive.  It also includes retirement benefits the deceased was entitled to receive, such as annual income from an IRA or 401(k).

As you probably know, anything you own or control at the time of your death (mutual fund, half-interest in a vacation home, life insurance policy, etc.) is included in your "estate".  While you can currently leave an unlimited amount of property to a spouse without triggering any estate tax, you can only pass a certain amount of assets to non-spouse beneficiaries estate tax-free.  This year, for instance, that total amount is $1,000,000. Leave your kids or anyone other than your spouse more than that and your estate will owe estate tax on the amount over a million bucks.

Let me walk you through a simplified example, with thanks to Bruno Graziano, one of the experts at CCH, a nationally-recognized provider of tax information, who was kind enough to work up the numbers based on my hypothetical dead person:

Grandpa dies this year, leaving an estate valued at $3.5 million to his son and grandson.  The grandson is the beneficiary of Grandpa's traditional IRA worth $1.1 million.

Since the IRA was owned by Grandpa, it is considered his property at the time of his death and included in his estate. Grandma passed away years ago and Gramps never married his young girlfriend, so none of his estate is going to a spouse;  all of it is left to non-spouse beneficiaries. That means $2.5 million will be subject to estate tax.

Without going into the exact steps involved, Graziano calculates grandpa's estate owes $1,180,000 in estate tax — ouch!  And almost half of that — $549,000 — is due to the IRA left to his grandson.

Hopefully, Grandpa had a team of sharp advisors who told him to take out a life insurance policy on himself, but make someone else — probably his son — the owner. (Now,why should someone else own the policy?*) The life insurance policy would cover the estate tax bill.

Here's where IRD (remember what that stands for?) comes into the picture. When someone who inherits your IRA (except if it's a "Roth" IRA) starts taking the money out, they have to pay income tax on the withdrawal. That's because none was paid when the money went into the account.

So, say the grandson withdraws $200,000.  That amount is added to his income for the year and taxed at ordinary income tax rates.  In this case, it puts him in the highest tax bracket: 38.6%.  His tax bill that year for the IRA income alone is $77,200!

In most instances, people will just utter %$#@?&!, grit their teeth and write a check to the IRS.  They console themselves that "at least" they came away with $122,800.

But if you've got a sharp tax or financial advisor they'll realize you don't owe anything near that amount.

Here's why: The government doesn't expect you to pay tax twice on the same income. Remember, the decedent — grandpa — paid  estate tax on the IRA.  So when the grandson takes the money out, thanks to IRD, he gets a deduction to offset the tax that's already been paid on this income.  This erases almost all the tax due!

A couple of points:

— You don't get to claim a deduction for IRD unless the person who left you the asset actually paid estate tax on it.  Unless their estate was worth more than a million bucks, this won't apply to you.

— The IRD is fully deductible.

— Finally, this is too important to leave to someone who's not a professional — you, yourself, for instance!  Get a competent tax or financial advisor to work up the calculations for you.

I know this won't affect everyone.  But these days more and more people own 401(k)s, IRAs and other pots of retirement income.  And these amounts can add up quickly.  Money magazine estimated that by 2010, 10% of all 401(k) owners will have at least a million dollars in their account.

If you inherit someone's retirement plan, find out if their estate paid any estate tax.  If it did, you might be able to offset any income tax you owe when you withdraw money from that account.

Gail

* Because if gramps owned the policy, it would be included as his property and added to his taxable estate, resulting in an even larger estate tax bill!

Can you recommend a few fund companies to invest with for the 529 College Savings Plan?

Thank you,

Deanna

Dear Deanna-
I suggest you start by visiting a website which provides basic information about 529 college savings plans as well as links to every sponsor: www.savingforcollege.com.

First check to see if the 529 plan sponsored by your state offers any tax breaks to state residents.  For instance, some sponsors give you a tax deduction for a certain amount of your contribution.  While this sounds like something you should never pass up, it's not that simple.  Many states limit the amount of any deduction you get, so your tax savings isn't as great as you might think.

Also, keep in mind that by reducing your state income tax, you increase your federal income tax — because you have less in state tax to subtract, your income subject to federal tax is higher. And your federal tax rate is going to take a bigger bite.  What you should look at is your net tax savings after you consider the impact at both levels of taxation.

Frankly, the longer your time horizon — that is, the younger the child whose education you are saving for — the more important investment performance becomes.  Over time, earning just a slightly higher return each year can more than compensate for any upfront tax break you get.  So be sure to check out the reputation of the company managing the investments in a 529.

Shop around.  There is no single standard for 529 plans.  Each one is different.  And, as you know, you don't have to use a particular state's 529 in order to receive the federal tax benefits (for instance, tax-free withdrawals provided the money's used for qualified college expenses).

But whatever plan you decide upon, the 529 is the best way to save for a child's college education.

Good luck!
Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to moneymatters@foxnews.com  along with your name and phone number.

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.