Tax Issues to Handle When a Loved One Passes

It happens to all of us at one point or another: we lose a loved one to old age, illness, or accident.

Along with the grief attendant on such an experience, there are also, unfortunately, plenty of legal and financial issues to manage when a loved one passes. If you’re not prepared for these, the grieving period can be made even harder by financial and legal stress. 

If you’re the executor, or the one managing the deceased’s affairs, here are some of the most important things you need to know. 

What does an executor do? 

The executor of the deceased’s estate is the person designated to identify the decedent’s assets, pay off any debts, and make sure that what is left gets distributed to the heirs and beneficiaries that the decedent identified. 

That also includes filing tax returns and paying any outstanding taxes. You can see the first part of this article series here, which outlines some of those. For more, keep reading. 

Federal income tax considerations

One of the first major tax considerations for the executor of the decedent’s estate is filing the decedent’s federal income tax return. Any income generated by the decedent’s holdings after their passing belongs to the estate.

The estate’s initial federal income tax year begins immediately after the decedent’s death. The tax year ends either on December 31 or the end of any other month that results in an initial tax period of 12 months or less.

You’ll need to file the return on Form 1041 (U.S. Income Tax Return for Estates and Trusts). 

However, you won’t need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs. This would happen with: 

  • Real property owned by joint tenants with right of survivorship
  • Qualified retirement plan accounts and IRAs that have designated account beneficiaries
  • Life insurance death benefits that are paid directly to designated policy beneficiaries.

The unlimited marital deduction

If the decedent’s surviving spouse is a U.S. citizen, she or he can inherit unlimited assets, free of any current federal estate tax. This is called the “unlimited marital deduction privilege.” 

This can be a major benefit for large estates, as, along with the estate tax exemption of up to $11.58 million, it can allow them to avoid any current federal estate tax liability.

Life Insurance benefits

Typically, life insurance proceeds are free of federal income tax—however, they are usually included in the decedent’s estate for federal estate tax. This is true even if the benefits pass directly to a designated beneficiary. 

The exception to this is if the beneficiary is a surviving spouse. Any assets inherited by a surviving spouse, including life insurance benefits, are not included in the decedent’s estate to calculate estate tax as long as the surviving spouse is a U.S. citizen.

Medical expenses 

Another area that deserves careful consideration is the tax treatment of your loved one’s medical expenses. 

If the decedent incurred uninsured expenses that were not paid before death, the executor has a choice to make. Here are your options. 

Along with any medical expenses that have already been paid in the year of death, the executor can choose to deduct medical expenses that have not yet been paid on the decedent’s final Form 1040. To do this you should choose an accrual basis. If the decedent’s final Form 1040 itemizes deductions, the combined paid and unpaid expenses would need to exceed 7.5 percent of adjusted gross income (AGI). 

To itemize deductions for unpaid medical expenses, you must pay the expenses out of the decedent’s estate during the one year beginning with the day after the date of the decedent’s death.

If, however, the estate is subject to federal estate tax, the executor can choose to deduct unpaid medical expenses on the decedent’s federal estate tax return, instead of on the decedent’s final Form 1040. 

Since only a very small percentage of estates are subject to estate tax—because, as mentioned before, the federal estate tax exemption for a person who passed away in 2020 is $11.58 million—it’s unlikely that you’ll need to consider deductions using the estate tax return. 

Making financial arrangements to manage the estate

Forms you may need to file include the decedent’s final Form 1040, the estate’s Form 1041 income tax return, and the estate’s Form 706 (estate tax return, only applicable for estates worth more than $11.58 million).

Form 1041 won’t apply when all the decedent’s income-producing assets bypass probate and go directly to the decedents’ heirs. 

If you do need to file Form 1041 and/or Form 706 you’ll need to obtain a federal employer identification number (EIN) for the estate. 

To apply for an EIN, fill out Form SS-4 (Application for Employer Identification Number).

After that, you’ll need to file Form 56 (Notice Concerning Fiduciary Relationship) to notify the IRS that you, as the executor, will be acting on behalf of the estate in financial and tax matters. 

Finally, you’ll need to open a checking account in the name of the estate and transfer some of the funds of the estate into it. This can be used to pay expenses related to the death, as well as the estate’s needs.

Being the executor of someone’s estate is no small task. It can be made much easier with the help of a tax planning professional, relieving stress and ensuring that you’re taking advantage of every tax reduction strategy available. 

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