Back in July, I wrote about tax issues involving gifts and inheritances. Not all tax topics fit easily into a fixed space. In order to keep that column focused on estate and gift tax, I just noted that the act of making a gift or bequest does not create an income tax liability for the recipient.

That statement is a simplification, and, as I have come to realize, a potentially confusing one. These days, much of the assets that change hands when someone dies are not owned directly by the deceased, but are held in a retirement plan for the benefit of the deceased. And the income tax treatment of those situations is entirely different.

Hold On

There are dozens of types of retirement plans'IRAs, 401ks, profit-sharing plans and pension plans are the most common. All of these plans are trusts. A trust is nothing more than a contractual arrangement among three parties: a grantor, a trustee and a beneficiary. The grantor gives the trustee assets to hold for the benefit of the beneficiary; the written trust instrument guides the trustee in investing the assets and ultimately in disbursing them to or for the beneficiary.

Trusts are used for many purposes, not just accumulation of assets for retirement. Retirement plans are special trusts designed to meet the extraordinarily complex criteria of certain sections of the Internal Revenue Code which allow highly favorable tax treatment. The grantor is allowed to take an income tax deduction for the assets given to the trustee to hold and invest until the beneficiary reaches retirement age. (The grantor may be the same person as the beneficiary, as in an IRA, or may not be, as in a plan funded by an employer.) Unlike most trusts, the annual earnings of retirement plans are not subject to income tax. Income tax arises only when money (or other assets) are distributed to the beneficiary. Even then, the trust does not pay tax, the beneficiary does.

And therein lies the point of confusion. The person who died was the primary beneficiary of the plan. Those receiving assets after death are, technically, the contingent beneficiaries of the trust, and that transfer of assets is not, technically, a bequest.

And when assets are distributed from this type of retirement plan, income taxes must be paid.

Holding It In

All too often, successor beneficiaries simply take the money out of the retirement plan immediately, pay the income tax, and complain. Perhaps they don't ask, or perhaps they are given obsolete (or wrong) information, but there are alternatives.

If you were legally married to the deceased, you can treat the entire balance as if it were your own IRA, and have an unlimited right to draw funds from it even if you are below retirement age. That's easy, and almost always a good idea. Otherwise, you must start drawing the money out, but you can do so at a slower pace, allowing further tax-free earnings, and perhaps cutting the overall amount of taxes by not having an unusually high income in any one year.

How slowly the distributions can be made depends, in part, on whether the deceased had begun drawing money from the plan. If he or she had, the remaining balance must be distributed at least as rapidly as under the method of distribution in use at the date of death. That could be pretty slow. The required minimum distribution rules are exceptionally complex, even by the standards of this part of tax law. But in most cases, the distribution period is over the joint live expectancy of the deceased and the beneficiary (presumably younger) at the time distributions began. The exact time span depends on the age of each, but it will be at least a few years, and could be more then twenty.

If the deceased had not begun drawing from the plan before death, the rule may be the same. Or it may not, in which case distributions must be completed five years from the date of death. If the plan documents specify one or the other, the plan rules govern. Otherwise, the life expectancy rules apply if a specific beneficiary is named in the trust's records, and the five-year rule applies if the beneficiary is determined by state law or by being named in the will.

There are subtle exceptions to these rules, and some company-funded retirement plans, particularly those of the 'defined benefit' flavor, may have more restrictive rules. But you should at least ask.

Roth IRAs, as I mentioned earlier, are handled a bit differently, mostly because distributions from them are not subject to income tax. Usually, the required distribution will be over the beneficiary's life expectancy, but sometimes the five-year rule applies depending on subtle differences of situation and arcane rules.

Which brings me back to the key point. If you are the beneficiary of someone's retirement plan, and the custodian or trustee or lawyer handling the estate says you have to take it all in one lump sum, say, 'Are you sure?' And if you get a quick, glib, certain response, keep pushing. Make them work for their fee, so you don't have to pay excess taxes.

Last Call for Amnesty

For those of you still contemplating doing something about stale Illinois tax debts, the last day for paying them and receiving a waiver of penalty and interest is Nov. 17. After that, the penalty and interest double.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theater companies and suppliers. He also sometimes produces theater.

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