August 10, 2023

Tax Planning after the Death of a Spouse

Around 1.5 million Americans become widows and widowers annually, with two-thirds of surviving spouses being women. Dealing with tax responsibilities after the passing of a loved one is emotionally overwhelming. In this blog I will briefly explain main tax issues that arise after death and hopefully this information will guide you in a right direction.   

One question that comes up very often is whether the surviving spouse must file an estate tax return, specifically Form 706. Notably, most Americans aren't obliged to pay estate tax due to the substantial current estate tax exemption—$12,920,000 for an individual or $25,840,000 million for a married couple (2023 data). In fact, IRS data from 2020 revealed that only about 1,900 individuals paid tax through this return. Despite the limited number of cases where taxes are due, filing an estate tax return can still serve a vital purpose—the concept of portability.

Portability enables a surviving spouse to utilize the unused estate tax exemption of the deceased spouse. This involves transferring the decedent’s unused exclusion (DSUE) amount to the surviving spouse via Form 706. If one spouse passes away without fully utilizing their federal estate tax exclusion amount, the remaining unused portion will be given to the surviving spouse. This increases the surviving spouse's own estate tax exclusion and offers additional protection against potential estate taxes. Additionally, portability acts as a shield against possible tax adjustments in the future. In light of recent discussions within Congress about potential reductions of exemptions, filing an estate return will secure a substantial exemption for the surviving spouse, mitigating concerns regarding future tax alterations.

Understanding the timing for an estate tax return is also crucial. Generally, the return is due within nine months of the decedent’s passing. However, there's room to request an extension under Rev. Proc 2017-34. Also, If the estate tax return is filed solely for portability reasons, the IRS allows additional two years to file the return.

Tax brackets shifts. Whether the spouse's passing occurs on January 1 or December 31, the surviving spouse will file their taxes as "married filing jointly" for that year. But things change in the next calendar year – the surviving spouse typically needs to file as "Single" (unless they remarry). This transition prompts a crucial consideration: how the shift in tax brackets could impact your financial situation. This is where your CPA steps in to guide you through these changes.

As most of us are aware, the tax bracket for "married filing jointly" is usually more advantageous compared to that for "Single" filers. This means that, on the same income, a surviving spouse would end up paying significantly less tax while filing jointly rather than as "Single." Your tax CPA is here to help. The CPA will run tax projections and inform you about any potential increase in your tax burden for the upcoming year and may be will give you new estimated vouchers. One interesting idea to explore is accelerating income in the year of the spouse's death. For instance, your CPA might suggest a Roth conversion during this time to capitalize on the benefits of a lower tax bracket.

However, there's another aspect to consider – the possibility of tax liabilities being passed on to the surviving spouse when filing "Married Filing Jointly." For instance, if the deceased spouse owed taxes, filing jointly could result in the surviving spouse becoming responsible for that debt. In addition, if a tax refund is due, the IRS might use it to offset any outstanding taxes. In such cases, your CPA's expertise is invaluable. They can conduct a detailed comparison between "Married Filing Joint" and "Married Filing Separate" to determine the best approach for your situation.

Step up and Step down in Basis. Under current law, when someone passes away, the property of the deceased person receives a step-up in basis. A step-up in basis occurs when the property is given a new cost basis based on its FMV (Fair Market Value) at the time of death. Properties such as houses, stocks, and existing businesses are usually the most common assets to undergo the reset in their basis. In community property states, the survivor gets a full step-up. In non-community property states, the survivor receives the step-up only for the deceased person's portion of the property.

How does this work in an example? Let's say you own a house that you purchased in 1980 for $200,000. At the time of death, the house is now worth $1.1 million. In a community property state, the basis steps up to $1.1 million, which was the FMV at the time of death. However, in a non-community property state, the basis only increases to $650,000. ($1,100,000/2 + $200,000/2 = $650,000)

There is also the concept of a step-down in basis. If a property decreases in value from the purchase price or acquisition price, a step-down in basis occurs. This step-down in basis can lead to capital gains in the future when the deceased person's property is sold. Therefore, if a tax CPA has a client whose health is failing, they may suggest gifting the property to the surviving spouse. This way, the property will solely belong to the surviving spouse, and the property will retain its original high-cost basis.

Sale of home. Many clients often contemplate leaving their homes, downsizing, or relocating due to painful memories after the loss of a spouse. It's crucial for their CPA to discuss the exclusion from the sale of a home with them. The married filing jointly status allows for a gain exclusion of $500,000 from the sale of a home. However, this exclusion reduces to $250,000 for a surviving spouse, but only after two years from the date of death. So, if the surviving spouse sells the home two years after the death, they are still eligible to utilize the $500,000 exclusion. If more time passes, the CPA can still save money for the client by using the step up in basis rule we discussed earlier.

Retirement accounts. In the realm of estate planning, retirement accounts hold a significant place – often second only to our homes. If the surviving spouse is under 59½, rolling over the IRA might not be recommended to maintain flexibility for penalty-free withdrawals. There is no 10% penalty for withdrawals from spouse-inherited retirement accounts. However, if the young surviving spouse rolls over the retirement funds to their own account and then withdraws them, they will face a 10% penalty if their age is under 59½ (and if you are in California, an additional 2.5 % on top of that to the state). For those younger than 59½, leaving the account in the decedent's name could be more prudent. On the other hand, when a surviving spouse is younger than the original account owner, rolling over the inherited IRA into their own IRA might allow them to delay Required Minimum Distributions (RMDs) until they reach the age of 72. This is because RMDs from the surviving spouse's own IRA are not required to begin until age 72 under current U.S. tax laws.

Navigating tax planning after a spouse's passing is overwhelming. The article covers key considerations, such as estate tax exemption, portability benefits, tax bracket shifts, step-up/step-down in basis, sale of home rules, and retirement account strategies. Hopefully. It can give surviving spouses enough information to make informed financial decisions in such a challenging time.