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FACTS: Assume your clients, both age 70, have an estate equal to $2.5 million dollars, consisting of mostly liquid rental property. The one liquid asset is an IRA valued at $500,000 owned by the husband and the wife is the primary beneficiary.

They have done some estate planning and currently have wills utilizing each individual's unified credit exemption equivalent. Each spouse owns $1 million dollars of assets in their individual names. The clients indicate that they don't need the income from the IRA because the rental property provides more than what they need to maintain their standard of living. They desire to leave their entire estate to their two children and want to minimize loss caused by taxation.

You informed them that even if the recent estate tax legislation shelters their estate from estate taxation; the IRA will be subject to income taxation.

They are interested in reviewing how life insurance may be a solution to help assure needed liquidity to pay taxes and pass their entire estate to their children.

Solution: Many people conserve their IRAs and other qualified plan assets with the intention of passing those dollars on to their heirs. Although qualified plans are generally the best way to accumulate dollars for retirement, they are not necessarily good vehicles for passing money to future generations. This is because qualified money is not only potential subject to estate taxation; it is always subject to income taxation.

For estate tax purposes, an individual who dies after becoming entitled to income, but who has not actually received it before death, is generally required to include this income in his or her taxable estate. Such income is termed "income in respect of a decedent", or IRD. Common sources of IRD include earned but unpaid wages, untaxed interest on U.S. savings bonds, and untaxed distributions from annuities, qualified plans and IRAs.

For income tax purposes IRD assets, unlike other assets, do not receive a stepped up basis at the death of owner. Even during the one-year period of estate tax repeal, executors are not permitted to allocate the $1.3 million limited step up in basis to IRD assets. In both situations, the recipient of the IRD (the heirs) must include it as taxable income, in the year received. If it turns out that the clients assets are subject to estate tax the recipient of IRD is allowed an income tax deduction for the amount of federal estate taxes that is attributable to the IRD.

In the clients situation if we assume both spouses die in 2002 the IRA will be subject to both estate and income taxes. Even after taking into consideration the IRD income tax deduction, the heirs will pay taxes of $328,405 (161,700 + 48,300 + 118,405) a loss of approximately 65% of the IRA. If we assume the clients live to 2004 and their estate is sheltered from estate taxation the heirs will still lose $175,000 (assuming a combined income tax bracket of 35%) of the IRA to income taxation. Bottom line, estate tax repeal did not repeal taxes for individuals with large qualified plan balances.