After someone dies, they will still owe their final income taxes for the year they died, which you must file.
The estate may also be liable for tax on any income it continues to earn.
Most inheritance is not taxable, but you may owe taxes on interest or capital gains.
Estate taxes and inheritance taxes only apply to estates worth millions of dollars.
As you sort through your loved one’s finances, you may feel worried about and overwhelmed by the different types of taxes that may apply to your situation. It’s true that there are several important things to consider, including variations between federal and state tax laws and potential tax implications for inherited wealth. And if you are the executor or administrator of the estate, you should know that you can be held personally liable for misfiling taxes on behalf of the estate, even if you hire someone else to prepare the taxes.
But no matter what your situation, rest assured that there are some basic rules and guidelines in place that can help you pinpoint areas of concern and allow you to easily cover your bases. As always, if you find yourself with outstanding questions, or are just feeling too overwhelmed to deal with these matters on your own, seek the guidance of an experienced lawyer, accountant, or personal financial manager for support.
If you are the person managing your loved one’s finances, you will need to file a personal tax return for them that covers the time up until they passed away. This means if they died in June of 2020, you will need to file a personal tax return on their behalf by April 15, 2021, covering the first six months of 2020. If they passed away in February of 2021, and had not yet paid 2020 taxes, you will be required to file their last two income tax returns, one covering 2020, and one covering the first 2 months of 2021.
To do their taxes, you fill it out exactly as they would have while they were alive, using the standard Form 1040. If the person was married at the time of their passing, their spouse can file a final joint return as they typically would if their partner was still living. This return will include the person’s income and deductions up until their time of death along with the surviving spouse’s full year’s worth of information.
Once the person’s final return is filed, if there are any taxes owed, these will come out of the remaining assets in the estate. If there is a refund due, this will be paid out to the estate and can then be distributed to beneficiaries along with whatever other money is left. If the estate doesn’t have enough money to pay the tax bill, the executor will have to petition the court to declare the estate insolvent.
If the estate itself continues to generate its own income after the person passes away—for example, if there is rent coming in from properties the estate owns—there is a chance you will need to file a separate tax form called a 1041. This is an income tax on money earned by the estate, totally separate from and unrelated to any federal or state estate taxes.
This tax only applies to estates that generate more than $600 in a year, so if you are dealing with a small estate, one that can be closed out before it makes $600, or with accounts that bypass probate and pass directly to beneficiaries, you don’t need to worry about filing a 1041. You can also deduct any disbursements to beneficiaries or costs of administering the estate from the total as well.
In general, beneficiaries do not have to pay taxes on anything they inherit, with a few notable exceptions.
If you are dealing with a sizable estate that earns more than $600 of income within the year even after any deductions, you will need to obtain a tax ID dedicated to the estate itself. (You will also have to obtain such an ID number for opening a probate checking account should you decide to do so.) This is so that the IRS can keep the affairs of the estate separate from any one person—you, your family members or the person who has died.
The above only applies to income earned by your loved one while they were alive, or by their estate after they passed away, not to any money that passed from them to their beneficiaries. In general, beneficiaries do not have to pay taxes on anything they inherit, with a few notable exceptions.
If you inherit a bank account, you won’t pay money on what is in the account, but if the account starts to earn interest, you can be taxed on that interest. Similarly, if your loved one leaves you the contents of a retirement account like a 401(k) or an IRA and you make a withdrawal from that account, there is a chance you will be taxed on what you withdraw.
Life insurance policies present a similar but also potentially confusing tax situation. If you are the beneficiary of a life insurance policy that is paid out in one lump sum, you will not be taxed. The money transfers to you and it is yours, tax-free. However, if you are paid in installments over the next several years, any interest that continues to accrue over those years can be taxed.
If an item you inherit earns you money, such as if you inherit a house and rent it out to tenants, you will owe regular income tax on the money you earn.
If your loved one leaves you an asset like a house or a car and you then sell that item for more than it was worth at the time your loved one passed away, you will have to pay capital gains tax on whatever extra you earn. So if your parent left you a house and you want to sell it, you can be taxed on any money you make on the sale that is more than it was worth on the date of your parent's passing. Only the "date of death value" is relevant here, not the value at the time it was purchased. If your parents made a great investment on a home 40 years ago, you will not be charged on the appreciated value of the home from 40 years ago, just on the recent appreciation since it became part of your parent's estate.
You may have heard the term “estate tax,” but just because you are dealing with someone’s estate does not mean it will be subject to estate tax. In 2021, the federal estate tax only applies to estates worth more than $11.7 million.
There is also an estate tax on the state level in 12 states and the District of Columbia. The threshold for these state estate taxes ranges from $1 million to $5.74 million.
Federal and state estate taxes are generally taken out of the estate before inheritances are disbursed, as part of probate. However, there may be situations, such as when all or most of the estate's assets pass to beneficiaries through revocable trusts or payable-on-death accounts, in which beneficiaries may have to pay the estate taxes out of assets that they have already received. Although such assets are not part of the probate estate, they are part of the taxable estate, and so if the estate does not have enough probate assets to cover its estate tax bill, these beneficiaries could be held liable for it.
There is also a state inheritance tax in six states, which applies to inheritances after they are disbursed. Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania have such taxes, but they only apply to inheritances in the millions of dollars, and typically only when the estate passes to a beneficiary who is not a spouse or member of the immediate family. If you live in one of these states, and the person who died was not closely related to you, and if after the estate settles you receive an inheritance of more than $2 million, there’s a chance you will be subject to an inheritance tax. If none of this applies, you are off the hook.
If you start to feel anxious thinking you might go into debt over taxes, remember that taxes are designed to be a percentage of earnings, not a tool for punishment. And that is especially so when it comes to inheritance. You will not go into debt trying to pay taxes on something of value your loved one left behind.
To the average person, tax laws can appear complex, tedious, and intimidating. Take heart knowing there are professionals available who handle just this sort of thing, and you can contact them at any time to get both advice and peace of mind ●
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Taxes can sound scary, but the truth is that in the vast majority of cases, paying taxes for your loved one and their estate is really very simple. There are several different kinds of taxes you will want to be aware of, however. Detailed information on each can be found right here.