When faced with the death of a family member or loved one, dealing with practical matters after death during a period of intense grief can seem overwhelming. Nonetheless, as Ben Franklin said “In this world nothing can be said to be certain, except death and taxes”. Sadly even death does not excuse a person from a final reckoning with the taxman and paying final income and estate taxes is part of finalizing an estate.
Federal and state income taxes
The state of California does not collect a death tax, but final state income taxes for the deceased must be paid. Final federal income taxes need to be filed as well. The final tax return is typically completed by the executor or a surviving family member. The filing deadline is still April 15th of the year following the tax payer’s death. The filer uses the same tax forms, but “deceased” is written after the tax payer’s name. If the deceased was married the surviving spouse may file a joint return for the year after the death.
Along with the final income taxes for the deceased, the estate will likely need an income tax filed as well. This tax return accounts for any untaxed income generated by the estate after the death. When filing income taxes for the estate you need to get an employer identification number (EIN), which will be used for banking and various monetary transactions for the estate. An EIN can be requested from the IRS website by completing a request form. Opening a separate bank account for the estate to pay various expenses while closing the estate is advantageous and the bank will ask for the EIN.
Income and deductions
When reporting income, only income from the beginning of the year until the death needs to be reported to the IRS. This applies to all forms of income including investment earnings. For example, if the tax payer dies on August 1st, only the earnings up to that date need to be reported on the final income tax return. However, bank and investment statements typically show income for the entire quarter of year. This is why gaining ownership of the account as soon as possible is beneficial.
A common misconception is that inherited IRAs and employee sponsored retirement accounts are not taxable, since most inheritances are not taxable. The only accounts not eligible for taxation are Roth IRAs and Roth 401ks that have been opened for a minimum of five years at the time of the tax payer’s death. When including deductions, all deductable expenses the tax payer paid before death can be written off. Additionally, all medical expenses paid within one year of the death can also be deducted.
Handling the final taxes is just one of the many roles of the executor, which is why it is important to choose your executor with care. It is also a good idea to consolidate or streamline finances when you get older. Having an estate plan in place and communicating your wishes in advance will make the process easier for everyone involved.