When a family member passes expected or unexpected there’s a tsunami of emotions. Unfortunately, there tends to be another tsunami behind the first and that is all the sleuth of financial decisions that must be done. Life is structured to make a lot of stressful decisions at an already stressful time. These decisions and duties often result in large financial implications. These tasks fall into two large broad strokes that must be tackled which are taxes & transitioning assets.
Final Tax Return
This is where the gloomy joke “two things you can’t get out of in life is death and taxes” by Benjamin Franklin comes into play. You must file the deceased’s last tax return (Form 1040 or 1040-SR, A). This return is due April 15th the following year of the persons passing.
In 2018 the estate and gift tax rose to $11.18 million per individual and $22.36 million per married couple. The estate tax and income tax are different. Therefore, the size of the estate may be below the $11.18 million individual or $22.36 million married limit but that does not mean you may not be required to file an estate tax return. Along with the Form 1040, you will also need to file an estate tax return (Form 1041) if any of the two conditions are true for the estate.
- gross income for the tax year of $600 or more
- a beneficiary who is a nonresident alien.
While you likely will file both returns Form 1040 & Form 1041 at the same time, it is important to note they are two distinct entities. It is wise to work with a tax professional to help you file these final returns because individuals don’t work with them often and there are nuances between filling a return in which you are alive versus a final return.
Example
A simple example of how you could end up needing to file both returns is as follows. Sally passes away on June 15th, 2020. Combining all her accounts, she has total assets of $3,000,000
Before Sally’s passing, she earned the following income: $25,000 in interest income from her bond portfolio, $30,000 in dividends from stocks she owned, and $150,000 in W-2 wages from her job.
After Sally’s passing, she earned the following income: $17,500 in interest income from her bond portfolio, and $10,000 in dividends from stocks she owned
The executor of Sally’s estate will need to file Form 1040 for the $205,000 ($25,000 interest, $30,000 dividends, and $150,000 W-2 wages) of income earned before her passing.
The executor will also need to file Form 1041 for the $27,500 ($17,500 interest and $10,000 dividends) of income earned after her passing.
The executor will also need to file Form 1041 for the $27,500 ($17,500 interest and $10,000 dividends) of income earned after her passing.
While the executor will need to file to pay income taxes on the estate; the executor will not need to file for the estate tax since the total estate is below $11.18 million.
Other important tax events that happen upon someone’s death is a cost basis step up. This increase in cost basis will reduce the future tax liability of the beneficiary of the taxable investments. Money held in retirement accounts cannot be held in the deceased’s name and will have to be distributed eventually creating a tax liability. Different retirement accounts have different distribution rules. An example is many IRA or 401(k) beneficiaries will have to distribute the assets within 10 years.
Inheriting financial assets
Upon someone’s passing how assets are distributed can vary greatly. It’s important to first identify where all the assets are and under what types of account structures. You will also want to see if there is any potential creditors and liabilities the estate will have to satisfy. Even after the tax returns are filled the thought of having to think of taxes still doesn’t disappear. Tax strategy becomes very crucial here. Real estate and investment securities receive a stepped-up cost basis when someone passes limiting the future tax liability for the beneficiary. Tax advantaged accounts have different distribution rules and distributions will need to be managed accordingly. When a non-spouse inherits an IRA after 2020, they will need to distribute the full account value within 10 years. An important point to note is the time of persons death is very important since the SECURE Act rules became effective Jan. 1st, 2020 anyone that is a beneficiary prior to 2020 of someone passing will be following a very different set of distribution rules.
Once there is a plan in place to transfer assets, it is then time to think of the asset allocation of the investment portfolio. While asset allocation is a huge piece of the puzzle for any portfolio it is hard to do properly before you know what assets will be left in the estate after liabilities and taxes are paid or where the assets will be held due to tax planning.
It is very likely how the assets were invested prior to the decedents passing are no longer optimal for your situation or other beneficiaries of the estate. Now aside from the dollar value strictly attached to a collectible or an old stock that your family held for a long time, these assets tend to have a lot of emotional meaning attached to them. Re-allocating inherited assets from an estate can be very emotional. That’s why it’s a good idea to work on the account placement strategy step first giving you more time to digest the situation not feeling rushed to immediately buy and sell assets. Everyone deals with loss very differently and your situation is completely unique to you. Nobody will be able to feel exactly what you feel, but a trusted tax advisor and financial advisor can help further guide you through the transition to at least help lift some of the stress off your plate.
Sources:
https://www.fidelity.com/learning-center/personal-finance/retirement/non-spouse-IRA
