When a loved one dies, someone must step up to handle the resulting financial matters. Often the person is named in the decedent’s will as the estate executor, but if there’s no will, the probate court can appoint an executor. It’s often the surviving spouse or another family member.
If you wind up with the job, your tasks include identifying the estate’s assets, paying off its debts, and then distributing whatever’s left to the rightful heirs and beneficiaries. You’re also responsible for filing any required tax returns and paying any taxes due.
Filing the Final Income Tax Return
The decedent’s (deceased individual’s) final Form 1040 covers the period from Jan. 1 through the date of death. The return is due on the standard date, meaning April 15, 2015, for someone who dies in 2014. If the decedent was unmarried, the final 1040 is prepared in the usual fashion. When there’s a surviving spouse, the final 1040 can be a joint return filed as if the decedent were still alive as of year-end. That final joint return includes the decedent’s income and deductions up to the time of death plus the surviving spouse’s income and deductions for the entire year. Note that you may also have to file a final state income tax return for the decedent.
Be sure to keep a careful eye on medical expenses. If large uninsured medical expenses were incurred but not paid before death, you — as executor — must make an important choice about how they are treated for federal income tax purposes. Along with any medical expenses paid before death, you can choose to deduct the as-yet-unpaid expenses on the decedent’s final Form 1040 to the extent they exceed 7.5 percent of adjusted gross income (AGI) or 10 percent of AGI for someone who dies before age 65. Final medical expenses can easily exceed the applicable percent-of-AGI threshold, especially when death occurs early in the year before much income has been earned. Being able to deduct incurred but not yet paid medical expenses is an exception to the general rule that expenses can only be deducted after they have been paid.
Alternatively, if the estate is subject to the federal estate tax, which generally only applies to estates of more than $5.34 million (for someone who dies in 2014), you can choose to deduct the incurred but not yet paid medical expenses on the federal estate tax return (more on that below), rather than the decedent’s final Form 1040. Obviously, if no federal estate tax is owed, this is not an option. But when estate tax is due, deducting medical expenses on the estate tax return is usually the tax-smart option. Why? Because the estate tax is 40 percent once the $5.34 million threshold is surpassed, while the decedent’s final federal income tax rate could be as low as 10 percent. Plus the full amount of the accrued medical expenses can be deducted on the estate tax return (not just the excess over the applicable percent-of-AGI threshold).
Filing the Estate’s Income Tax Return
You may also have to file a federal income tax return for the estate. This is entirely different from the federal estate tax return. Once an individual has passed on, any income generated by his or her holdings after death becomes part of the estate and is taxed on the estate’s own federal income tax return.
The estate’s first income tax year begins immediately after death. The year-end can be Dec. 31 or the end of any other month that results in an initial tax period of 12 months or less. You must file the estate income tax return on Form 1041 (U.S. Income Tax Return for Estates and Trusts) by the 15th day of the fourth month after the year-end you select. So for a person who dies in 2014, the initial estate tax return filing deadline will be April 15, 2015 if you choose the “standard” Dec. 31 tax year-end.
If you’re dealing with an estate that has annual gross income below $600, you don’t need to worry about filing Form 1041. Also, there’s no 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 by contract or by operation of law. This is what happens, for example, with real estate owned jointly with right of survivorship, with bank accounts with “pay on death” beneficiaries, with retirement accounts and IRAs that have designated account beneficiaries, and with life-insurance proceeds paid directly to designated policy beneficiaries.
If the estate is required to file Form 1041, I recommend hiring a tax professional with plenty of experience in this arcane area of the tax law. Note that you may also be responsible for ensuring that a state income tax return is filed for the estate — another reason to consider hiring a pro.
The Bottom Line
Dealing with an estate’s tax issues can be complicated: the bigger the estate, the more complicated. This is a situation where the extra cost of hiring a tax professional can be money well spent.
This article originally appeared on MarketWatch.com and is reprinted by permission from Marketwatch.com, ©2014 Dow Jones & Co. Inc. All rights reserved.