Income Tax
The deceased’s tax year ends on the day of death. For single taxpayers whose income is large enough, the executor or appointed personal representative must file a final income tax return by April 15 following the year of death. The final return includes any income actually received and deductible expenses actually paid prior to death. As a surviving spouse, you can claim a married filing jointly status in the year of your spouse’s death and treat his or her tax obligations as your own. Additionally, if you remain unmarried and care for a dependent child, you may be able to claim widow or widower status for two years following the year in which your spouse died. In both cases, this tends to result in lower taxes than if you file as single or head of household. Be sure to review the signature requirements for the returns in the instructions for IRS Form 1040.
An heir doesn’t generally incur federal income tax on an inheritance, but there are exceptions. Retirement assets, such as 401(k)s, IRAs, and annuities, are tax deferred while the owner is living; once they pass to the beneficiaries, taxation will continue to be deferred until distributions begin. You can usually arrange distributions so that the taxes are stretched out over time. It’s a good idea to talk to the retirement plan administrator or insurance company about your options.
Fiduciary Income Tax
Estates and trusts are treated as taxpayers and file IRS Form 1041 annually if their gross income exceeds $600. It is prudent to obtain taxpayer identification numbers for each entity as soon as possible and provide the numbers to financial institutions holding the estate or trust assets. This will help you avoid corrected 1099s, which could delay filing returns. Taxable income earned on assets held in an estate or trust should be reported to each entity. If taxable income is retained in the trust or estate, the entity must make estimated tax payments quarterly like any other taxpayer not subject to withholding.
The trust’s or estate’s tax liability may be shifted to the beneficiaries if distributions are paid to the heirs. The heirs will almost always pay less in taxes than a trust or estate would.
Estate and Inheritance Taxes
Larger estates may be subject to additional estate taxes. At the federal level, estates with more than $11,580,000 in assets (in 2020) may be exposed to estate taxes. For married couples, the unlimited marital deduction typically allows an estate to be transferred to the surviving spouse who is a U.S. citizen without any tax being due from the surviving spouse. In addition, federal portability allows for the unused estate tax exemption of a deceased spouse to be used by his or her surviving spouse, thereby enhancing the tax protection for the beneficiaries of the couple’s estate. Note that some states have enacted an estate tax or inheritance tax—or both—which may require additional estate planning. Keep in mind that tax liabilities are not limited to the state of residency, but rather where property is located, meaning the executor may have to file and pay taxes in several states.
Larger estates (i.e., those with property in excess of the exemption) can incur total taxes as high as 37 percent. This may require selling assets in order to raise cash. If the deceased arranged for a life insurance trust, it may be possible to sell assets to the trust or borrow from the trust in order to pay the tax bill.
Beneficiaries’ tax basis in most inherited property is equal to its fair market value (FMV) at the date of death. Consequently, a sale soon after death triggers little or no additional income tax. The heirs owe taxes only on the appreciation between the date of death and the date of sale. If the property passed to the beneficiaries through a trust, it is important to analyze whether that property was included in the decedent’s estate at the time of death to ensure that this basis “step-up” has occurred. Because the FMV of each asset needs to be established for both estate and income tax purposes, an appraisal soon after the death of the individual is often advisable.
Please note: Property passing through a decedent’s “estate” for estate tax purposes is different from the term “estate” as it applies to other principles (e.g., the decedent’s probate estate). Often, a decedent will have a large estate for estate tax purposes and little or no estate for probate purposes.
Certain documents will be filed with the estate tax return, including the decedent’s will, relevant trust documents, business balance sheets and profit and loss statements, brokerage and bank statements, property appraisals, and #IRS Form 712 for life insurance policies. Note that some expenses incurred by the deceased are deductible either on the final income tax return or on the estate tax return. Your accountant should compare the relative tax advantages of both options. In addition, the trustee and executor may make postmortem tax elections to minimize the future taxation of the estate and its heirs. A knowledgeable estate planning attorney or accountant can review the situation to determine whether such opportunities exist.
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This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. © Copyright 2020 Commonwealth Financial Network®. Presented by Sara Romaine. Sara Romaine is a financial advisor at Blue Hills Wealth Management. BHWM is located at 300 Crown Colony Drive, Quincy MA. Sara can be reached at 617-471-6800 or sara@bluehillswm.com. Securities and advisory services offered through Commonwealth Financial Network, Member, FINRA/SIPC a registered investment advisor. Fixed insurance products and services and College Planning services offered by Blue Hills Wealth Management and College Funding Solutions are separate and unrelated to Commonwealth.
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