By Bill Bischoff
A loved one who was “financially comfortable” has passed away. What happens now tax-wise? Good question, especially if you’re the one responsible for dealing with such matters. This column addresses some of the most important tax-related considerations. In an earlier column, I covered other important tax issues.
What are an executor’s responsibilities?
When a loved one (the decedent) passes away, someone must take on the job of winding up the financial aspects of the estate. That person may be identified in the decedent’s will as the executor of the decedent’s estate. If a family trust holds the decedent’s assets, the trust document will name a trustee. If there’s no will or trust, the probate court will appoint an administrator. In any of these scenarios, we will call that person the executor to keep things simple. That person might be you.
The executor’s assignment is to identify the estate’s assets, pay off the debts, and distribute the remainder to the rightful heirs and beneficiaries. The executor is also responsible for filing any necessary tax returns and arranging to pay any taxes. Let’s talk about those things.
How are basis step-ups for inherited assets calculated?
If the decedent left appreciated capital gain assets — such as real property and/or securities held in taxable accounts, the heir(s) can increase the federal income tax basis of those assets to reflect fair market value (FMV) as of: (1) the decedent’s date of death or (2) the alternate valuation date of six months later if the executor chooses to use the alternate valuation date. When an inherited capital gain asset is sold, federal capital gains tax is only owed on the appreciation (if any) that occurs after the applicable magic date. This pro-taxpayer rule can dramatically lower the tax bill.
* If the decedent was married and co-owned one or more homes and/or other capital gain assets with the surviving spouse, the tax basis of what was owned by the decedent (usually half) is stepped up to FMV as of the applicable magic date.
* If the decedent was married and co-owned one or more homes and/or other capital gain assets with the surviving spouse as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the tax basis of the entire asset is stepped up to FMV — not just the half that was owned by the decedent. This strange-but-true rule means the surviving spouse can sell capital gain assets that were co-owned as community property and only owe federal capital gains tax on the appreciation (if any) that occurs after the applicable magic date. So little or nothing may be owed.
How can gains from selling a principal residence be excluded from taxation?
An eligible unmarried individual can exclude from federal income taxation up to $250,000 of gain from selling a principal residence. Married joint-filing couples can exclude up to $500,000.
If the decedent was married, the surviving spouse is generally not allowed to file a joint return for tax years after the year during which the decedent died — unless the surviving spouse is a qualified widow/widower or he or she remarries. Nevertheless, an unmarried surviving spouse can usually claim the larger $500,000 joint-filer gain exclusion for a principal residence sale that occurs within two years after the decedent’s date of death.
This is a taxpayer-friendly rule, but pay attention to the deadline. Since the two-year period begins on the date of the decedent’s death, a sale that occurs in the second calendar year following the year of death but more than 24 months after the date of death will not qualify for the larger $500,000 gain exclusion.
On the other hand, if the surviving spouse sells at any time during the calendar year after the year that includes the decedent’s date of death (2020 if the decedent dies in 2019), the sale will automatically be within the two-year window, and the larger $500,000 gain exclusion will be available.
Key Point: Being eligible for the larger gain exclusion won’t matter if the home sale gain is $250,000 or less. That’s certainly possible, because the basis of any portion of the home that was owned by the decedent is stepped up. And if the home was owned as community property, the basis of the entire home is stepped up, as explained earlier.
What are the required minimum distribution rules for inherited retirement accounts?
The dreaded required minimum distribution (RMD) rules generally apply to inherited IRAs and inherited qualified retirement plan account balances. Beneficiaries cannot afford to ignore the RMD rules. Failure to withdraw the properly calculated RMD amount for any year exposes beneficiaries to a 50% penalty based on the shortfall between the required amount for the year and the amount actually withdrawn during the year, if anything. The 50% penalty is one the harshest punishments in our beloved Internal Revenue Code, and the penalty can stack up year after year until compliance with the RMD rules is achieved.
Which RMD rules apply to the surviving spouse beneficiary?
If the decedent’s surviving spouse is the sole beneficiary of the decedent’s IRA or qualified retirement plan account, special RMD rules apply. And an RMD may have to be taken as early as December 31 of the year that includes the decedent’s date of death.
The surviving spouse can usually achieve better tax results under the RMD rules if he or she can choose and does choose to treat the inherited account as his or her own account. Then RMDs can be calculated under the more-favorable rules that apply to original account owners. However, this choice may be unwise if the surviving spouse is much older than the decedent, because the election could accelerate the time for taking RMDs. Reason: RMDs would then be based on when the older surviving spouse (rather than the younger decedent) reached or reaches age 70½. Consult your tax adviser for details.
Warning: Say the surviving spouse is under age 59½ and needs to withdraw some money from the inherited account. Withdrawals while the account is still in the decedent’s name are exempt from the dreaded 10% early withdrawal penalty tax. However withdrawals from an account in the surviving spouse’s name are generally hit with the 10% penalty tax unless the surviving spouse is age 59-1/2 or older.
Other beneficiary scenarios
When one or more non-spouse beneficiaries (including the decedent’s estate or a trust) inherit a traditional IRA, Roth IRA, or qualified retirement plan account balance, other special RMD rules apply. Special rules also apply to accounts with multiple designated beneficiaries. You will be unsurprised to hear that these special rules can be complicated. And an RMD may have to be taken as early as December 31 of the year that includes the decedent’s date of death. Consult a tax professional for details.
The bottom line
When an unmarried individual passes away, the important federal income tax considerations explained in this column can apply. When a married individual passes away, the surviving spouse can often step into relatively favorable federal income tax rules. However, important timing considerations may apply. In either scenario, a tax professional can provide valuable assistance in meeting applicable tax compliance rules and in developing appropriate tax planning strategies for the future.