Tax Planning for After Death

Death and taxes may be equally inevitable, but the taxman demands the last word. Death does not excuse a final accounting with the IRS. Federal estate taxes could be due, and state inheritance taxes could come into play, too. Here, though, our focus is federal income taxes.

The Final Tax Return

When a taxpayer dies, a new taxpaying entity — taxpayer's estate — is born to make sure no taxable income falls through the cracks. Income is taxed either on the taxpayer's final return, on the return of the beneficiary who acquires the right to receive the income, or, if the estate receives $600 or more of income, on the estate's income tax return.

The chore of filing the taxpayer's final return usually falls to the executor or administrator of the estate, but if neither is named, a survivor must do it. The return is filed on the same form that would have been used if the taxpayer were still alive, but deceased is written after the taxpayer's name. The filing deadline is April 15 of the year following the taxpayer's death.

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If the taxpayer was married, the widow or widower may file a joint return for the year of death, claiming both personal exemptions and the full standard deduction and using joint-return rates. (For the two years following a husband's or wife's death, the surviving spouse can file as a qualifying widow or widower. That basically lets you continue to use the same tax brackets that apply to married-filing-jointly returns.)v

If an executor or administrator is involved, he or she must sign the return for the decedent. When a joint return is filed, the spouse must also sign. When there is no executor or administrator, whoever is responsible for filing the return should sign the return and note that he or she is signing on behalf of the decedent. If a joint return is filed by the surviving spouse alone, he or she should sign the return and write “filing as surviving spouse” in the space for the other spouse's signature.

If a refund is due, there's one more step. You should also complete and file with the final return a copy of Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer. Although the IRS says you don't have to file Form 1310 if you are a surviving spouse filing a joint return, you probably should file the form anyway to head off possible delays.

Reporting Income

Only income earned between the beginning of the year and the date of death should be reported on the final return. For taxpayers who use the cash method of accounting, as most do, income is considered earned as it is actually received or made available to them. Taxpayers who use the accrual method of accounting, on the other hand, count income as earned when they actually earn it, regardless of when they receive it. The distinction is important because some income that might logically seem to belong on the decedent's final return is considered “income in respect of a decedent” and is taxable either to the estate or to the person who receives it.

Income in respect of a decedent encompasses only income that the decedent had a right to receive at the time of death but that is not reported on the final return. It does not include earnings on savings or investments that accrue after death. Say a taxpayer who has a substantial amount in money-market mutual funds dies June 30. Only interest earned up to and including that date would be reported on the final tax return. Earnings after that date are taxable to the beneficiary of the account, or to the estate.

That can create some hassles because the payer — a mutual fund, bank or broker, for example — will report income to the IRS on a 1099 form. Although you should try to get ownership of the account changed as quickly as possible after the death of the owner, the 1099 income report may well show more income assigned to the decedent than it should. In such cases, you must report the entire amount on Schedule B of the decedent's return and then deduct the amount that is being reported by the estate or other beneficiary who actually received the income.

Money you inherit is generally not subject to the federal income tax. If you inherit a $100,000 certificate of deposit, for example, the $100,000 is not taxable. Only interest on it from the time you become the owner is taxed. If you receive interest that accrued but was not paid prior to the owner's death, however, it is considered income in respect of a decedent and is taxable on your return.

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Inherited IRAs and Retirement Accounts

A major exception to the general rule that inheritances are income-tax free — and one that is taking on more and more importance — is that money in IRAs, company retirement plans, including 401(k)s and 403(b)s, and annuities is treated as income in respect of a decedent and therefore taxed to the heir.

An important exception to this major exception covers Roth IRAs and Roth 401(k)s. Distributions from inherited Roth IRAs are taxed the same as distributions to the original owner. Any payout representing contributions or amounts that were converted from a traditional IRA come out first and are always tax free. Earnings come out last and are tax-free, too, if at least five years has passed since the original owner opened the Roth IRA.

The law now allows anyone who inherits a traditional IRA the right to roll over that money into an inherited IRA and spread distributions and associated tax bills over his or her lifetime. While no mandatory distributions are required for original owners of Roth IRAs, inherited Roths are a different matter. The new owner must either cash out the account within five years or begin withdrawals based on his or her life expectancy by December 31 of the year following the year the original owner died.

U.S. Savings Bonds

There's a special rule for U.S. savings bonds, on which interest generally accrues tax free until the bonds are cashed. When the bond owner dies, the accrued interest may be treated as income in respect of a decedent. In that case, the new owner of the bonds becomes responsible for the tax on the interest accrued during the life of the decedent. (The tax isn't due, however, until the new owner cashes the bonds.) Alternatively, the interest accrued up to the date of death can be reported on the decedent's final tax return. That could be a tax-saving choice if he or she is in a lower tax bracket than the beneficiary. If that method is chosen, the person who gets the bonds includes in his or her income only interest earned after the date of death.

Deductions

On the deduction side of the ledger, all deductible expenses paid before death can be written off on the final return. In addition, medical bills paid within one year after death may be treated as having been paid by the decedent at the time the expenses were incurred. That means the cost of a final illness can be deducted on the final return even if the bills were not paid until after death.

If deductions are not itemized on the final return, the full standard deduction may be claimed, regardless of when during the year the taxpayer died. Even if death occurs on January 1, the full standard deduction is available. The same goes for the taxpayer's personal exemption.

Property

Although special rules apply to a relatively small number of heirs who inherited property in 2010, in the vast majority of cases, the tax basis of inherited property — that is, the value from which the heir will determine gain or loss when he or she sells inherited assets such as stocks, mutual fund shares and real estate — is the value of the property on the date of death of the previous owner. We call this "step up" of basis the Angel of Death tax break because it effectively forgives the tax on any appreciation during the previous owner’s lifetime. If Uncle Joe bought a stock for $10,000 and it was worth $20,000 when he died, the niece who inherited the stock owed a capital gains tax only if she sold for more than $20,000. If she sold for less, in fact, she'd have a tax-saving loss, even though she'd be ahead of the game financially.

This same rule applies to most people who inherited property from someone who died in 2010, If you inherited assets that year, check with the executor of the estate to pinpoint your basis.