When a spouse, friend, or relative passes away, tax considerations are the last thing on our minds. Many of us are focused on the grief of loss and immediate funeral or memorial considerations. It may be helpful to work with a tax professional during this difficult time, such that someone else can manage the intricacies of the process for you. However, understanding the broad tax considerations after the passing of a loved one is also important in knowing where to start.
1. Taxation on inherited investment accounts.
If you are the beneficiary of an IRA, brokerage, or other investment account, it’s helpful to understand the different ways those accounts are taxed. Inherited IRAs will be rolled into a beneficiary IRA that must then be depleted within 10 years of your loved one’s passing. You can withdraw that money in any way you see fit over the course of 10 years, but keep in mind, every withdrawal will be taxed as ordinary income. Planning larger withdrawals during lower income years can be beneficial, as can evenly spacing out withdrawals to spread out the tax burden.
An inherited brokerage account is treated as any other brokerage account for tax purposes. Each year, realized capital losses and gains are calculated, and as the taxpayer, you will either deduct capital losses or pay taxes on gains. Assets in an inherited brokerage account receive a step-up to fair market value on the date of the original owner’s passing. You can also opt to have the assets valued on an alternative valuation date, but the final value cannot exceed the value determined for estate tax purposes. All assets within an inherited brokerage account automatically have a long-term holding period and accordingly are subject to the more favorable long-term capital gains rates.
2. Final tax return.
A surviving spouse or executor of an estate needs to file the deceased person’s final tax return in the year of their death. This is an income tax return, not an estate return. Any income incurred during the deceased person’s final year of life must be reported, even if received after their death. The surviving spouse can file a joint return as usual. The executor or surviving spouse must pay an income tax due, or they can claim any refund owed to the deceased person. The surviving spouse need only file the return to claim the refund. An executor or representative must file Form 1310 to claim a refund owed to a deceased taxpayer.
It can be helpful to locate the previous year’s tax return in order to know where to start. If you are unable to locate a copy of the previous year’s return, you can filed Form 4506-T with the IRS in order to request a transcript of the previous year’s return.
3. Estate tax return.
Most individuals will not need to file an estate tax return. In most cases, an estate tax return only needs to be filed if the gross estate of the decedent, increased by their taxable gifts and gift tax exemption, is valued above a certain threshold. In 2023, the estate tax filing threshold is $12.92 million.
There are two other situations where you may file an estate tax return. You would need to file an estate return to transfer any unused estate or gift tax exclusions from the deceased spouse to a surviving spouse. You would also need to file an estate return if the deceased person was a nonresident, non U.S. citizen who had U.S.-based assets.
4. Taxation of inherited property.
Similar to inherited brokerage accounts, inherited property receives a step-up to fair market value on the date of the original owner’s death or on another selected date. Inherited property is then given a long-term holding period, so will face more favorable long-term capital gains rates. Inherited property is not taxed until it is sold.
5. State inheritance taxes.
Six states currently impose an inheritance tax on beneficiary’s of an estate. Estate taxes are levied on an estate and generally paid out of the estate before assets are distributed to beneficiaries. Comparatively, inheritance taxes are charged to the beneficiary and are based on the amount received, rather than the total value of the estate. Generally speaking, the value of the inheritance must exceed a certain threshold for inheritance taxes to be imposed, and most states have additional inheritance tax exemptions. Currently, only Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania charge an inheritance tax.
