Amy Wang, CPA, senior technical manager of tax advocacy with the American Institute of CPAs, an accounting industry professional organization that has more than 400,000 members, Washington, DC. AICPA.org
Taxes are not the first thing on someone’s mind after the death of a spouse, but they are something that cannot be ignored for long. The recently widowed face special tax considerations, some of which may need to be dealt with well before the next tax-filing deadline.
Five things you need to know about taxes if your spouse recently passed away…or if you are helping a family member or friend whose spouse recently passed away…
• You might face massive tax penalties if you don’t withdraw money from your spouse’s IRA by the end of the year. If your spouse was age 70½ or older at the time of his/her death and had a tax-deferred retirement account, such as a traditional IRA, 401(k) or 403(b), your spouse was obliged to take a required minimum distribution (RMD) from the account each year. (This does not apply to Roth IRAs.) If your spouse had not yet taken the current year’s required distribution in the year of his death, then the account’s beneficiary—that’s often the surviving spouse—must do so on his behalf. The tax penalty for not doing so is a staggering 50% of the amount that was supposed to be withdrawn. That means thousands of dollars could be lost.
Unfortunately, many surviving spouses are unaware of this requirement…uncertain whether the deceased partner made the withdrawal…and/or not aware that the deadline for this withdrawal is the end of the calendar year in which your spouse died, not the April 15 tax-filing deadline.
Exception: The deadine is extended to April 1 of the year following the year in which the account holder turns 70½.
The financial institution that holds your spouse’s retirement account can help you determine whether RMDs are up-to-date and, if not, the size of the withdrawal required.
What to do: If the year-end deadline was missed, make the withdrawal as soon as possible. Then file IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, along with a brief letter explaining what happened and requesting a waiver of the penalty. The IRS sometimes will waive this penalty, particularly if the account owner died late in the year and the beneficiary makes the withdrawal early the following year.
• You have just nine months to preserve your deceased spouse’s estate tax exemption. Estate tax law offers a way for surviving spouses to preserve their deceased spouses’ estate tax exemptions. This essentially doubles the exemption available upon the second spouse’s death from $5.43 million to $10.86 million. (These figures will increase in the years ahead to keep pace with inflation.)
But there’s an often-overlooked deadline that must be met if you wish to do this—IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, must be filed within nine months of the date of death. This nine-month deadline often lands before the next tax-filing deadline, so even people who work with professional tax preparers might not learn about it until it is too late.
Some widows and widowers don’t bother preserving the exemption of the first spouse to die because the couple’s combined estate is less than the basic current exemption. But that’s a gamble—your assets could expand to exceed this exemption amount later.
Example: A man dies, leaving a $2 million estate to his wife. The wife does not bother preserving her husband’s estate tax exemption—but she lives another 20 years, during which time the couple’s assets climb in value to $8 million. Millions of dollars of the family’s wealth face federal estate taxes of as much as 40% that could have been avoided by a onetime filing.
• The timing of real estate sales can have major tax consequences following the death of a spouse. Some widows and widowers find it emotionally difficult to sell the family home even when it makes little sense to live there alone. If the home’s value has climbed significantly since you purchased it, there could be a tax reason not to wait too long. Married couples typically can exclude up to $500,000 of the profits from the sale of a principal residence from their capital gains taxes…while single people can exclude only up to $250,000. Unmarried widows and widowers still can qualify for the full $500,000 exclusion—but only if the home is sold within two years of the date of the spouse’s death. Don’t cut it too close to this two-year deadline—it might take months to find a buyer and weeks more for a home sale to close.
Other widows and widowers want to sell their homes quickly after the loss of their spouses because it is painful to live in their homes without their life partners…because they need the money…or because they cannot maintain the properties on their own. But selling too quickly sometimes can lead to unnecessary taxes, too. The capital gains tax exclusion can be claimed only if you have used the property as a primary residence for at least two of the past five years…and it has been at least two years since you last claimed this exclusion on the sale of a property. If you do not quite qualify under these rules, it might be worth delaying the sale until you do.
• You still might qualify for joint tax rates during the years following your spouse’s death. Married couples who file their taxes jointly receive a higher standard tax deduction than single people, plus more favorable tax brackets and higher income limits on many tax deductions and credits. The death of your spouse does not necessarily mean you no longer qualify…
• Widows and widowers can file jointly for the year of the spouse’s death even if the spouse died very early in the year.
• If there are one or more dependent children in your household, you can file as a “qualifying widow or widower” for two tax years beyond the year in which you were widowed, assuming that you have not remarried. (This provides the same rates and brackets as filing jointly.) After that, you might be eligible to file as a “head of household” if you still are supporting a dependent. The tax brackets are not as favorable with head-of-household status as they are for qualifying widows and widowers, but they are better than for single filers.
• You generally do not have to pay income taxes on life insurance benefits—with one exception. If the insurer pays you interest on a policy’s death benefits—say, because you agree to a deferred payout or an installment payout—that interest probably is taxable at your income tax rate. Ask your adviser or see IRS Publication 525, Taxable and Nontaxable Income, for details.