8.3 Estate and Income Taxation of IRAs: Gross Estate, IRD, and the Section 691(c) Deduction

Two Taxes on the Same Dollars

The third task in Domain 5 is estate and income taxation. IRA staff field questions such as "Will my children pay tax on this?" and "Is my IRA part of my estate?" The accurate answer is that an IRA can be exposed to two different federal taxes:

1. Estate tax on the value of everything the owner owned at death, including the IRA; and
2. Income tax on pre-tax IRA dollars when beneficiaries take distributions.

The Estate Tax Side

Inclusion in the Gross Estate

Under IRC § 2039, the value of an IRA is included in the owner's gross estate. The amount is the fair market value at the date of death (or the alternate valuation date if the estate elects it). The beneficiary designation keeps the IRA out of probate, but it does not keep it out of the taxable estate.

The 2026 Exclusion

The 2025 reconciliation law (P.L. 119-21) set the federal basic exclusion amount at $15 million per person for 2026, indexed for inflation after 2026, with no scheduled sunset. The top estate tax rate remains 40%. A surviving spouse can also use a deceased spouse's unused exclusion if the executor elects portability on a timely estate tax return. As a result, most IRA owners owe no federal estate tax, but very large estates still do, and some states impose their own estate or inheritance taxes with much lower thresholds.

Deductions That Reduce the Taxable Estate

• Marital deduction (IRC § 2056): an IRA left to a surviving spouse who is a U.S. citizen is generally deductible, deferring estate tax until the spouse's death.
• Charitable deduction (IRC § 2055): an IRA left to a qualifying charity is deductible for estate tax and, as noted below, escapes income tax as well.

The Income Tax Side: Income in Respect of a Decedent

Pre-tax IRA balances (deductible contributions and all earnings) were never taxed during the owner's life. They are income in respect of a decedent (IRD) under IRC § 691. That has three consequences:

1. No step-up in basis. IRC § 1014(c) denies a basis adjustment for IRD. A brokerage account inherited at a $500,000 value gets a $500,000 basis; a $500,000 traditional IRA gives the beneficiary no basis beyond any nondeductible contributions.
2. Taxed when distributed. The beneficiary reports each distribution as ordinary income in the year received (Form 1099-R, code 4), at the beneficiary's own tax rates. A trust that keeps distributions pays at compressed trust rates.
3. Basis carries over. If the owner made nondeductible contributions, that basis passes to the beneficiaries. A beneficiary tracks it on a separate Form 8606 for the inherited IRA, apart from any basis in the beneficiary's own IRAs.

The Section 691(c) Deduction

When an estate pays federal estate tax and the same IRA dollars are later taxed as income, IRC § 691(c) softens the double tax. The beneficiary may take an itemized deduction for the federal estate tax attributable to the IRD included in income that year. The deduction is listed in IRC § 67(b)(7), so it is not a miscellaneous itemized deduction and remains available even though those deductions are no longer allowed.

Simplified example: Suppose an estate paid $400,000 of federal estate tax, and the estate tax would have been $280,000 without the IRD items. The $120,000 difference is the estate tax attributable to IRD. If the beneficiary withdraws half of the IRD in one year, the beneficiary can deduct $60,000 that year. The estate's executor or tax adviser supplies the figures; the custodian does not compute them.

Roth IRAs and Estate Planning

• A Roth IRA is included in the gross estate like any other IRA.
• Qualified distributions to beneficiaries are income tax-free, and the Roth IRA has no IRD problem for qualified amounts.
• A Roth conversion during life moves the income tax bill to the owner. The tax paid leaves the estate, which can lower estate tax for very large estates, and the heirs inherit tax-free dollars.

Charitable Bequests of IRA Dollars

Because a charity is exempt from income tax and a charitable bequest is deductible for estate tax, leaving pre-tax IRA dollars to charity avoids both taxes on those dollars. During life, owners age 70½ or older can achieve a similar result with qualified charitable distributions (up to $111,000 for 2026).

Summary Table

Bank Operations: What the Custodian Supplies

• Date-of-death value. On the decedent's Form 5498 and annual statement, the custodian reports the FMV on the date of death in Box 5 (or uses the alternate method and tells the executor they may request a date-of-death valuation). Executors need this value for the estate tax return.
• Beneficiary reporting. Each beneficiary's distributions are reported on Form 1099-R under the beneficiary's own TIN with code 4.
• No tax advice. Questions about § 691(c), portability, or state inheritance taxes go to the executor's attorney or CPA.

Scenario

Rosa died in 2026 with a $3.2 million estate, including a $1.4 million traditional IRA split equally between her two children. Because the estate is below the $15 million exclusion, no federal estate tax is due and there is no § 691(c) deduction. Each child still owes income tax on the $700,000 IRA share as it is withdrawn, at ordinary rates, within 10 years. The bank provides the executor with the date-of-death value, sets up two inherited IRAs, and reminds the children that, because Rosa died after her RBD, annual RMDs are required in years 1 through 9.