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Tax Issues at the Time of Death

Introduction

The death of an account holder raises complex tax considerations for heirs, executors, and fiduciaries. Federal and state laws govern how income, deductions, and estate assets are treated for tax purposes. Proper planning and timely compliance are essential to avoid unnecessary tax liabilities and penalties. This paper outlines the primary tax issues that arise upon the death of an account holder.

Final Individual Income Tax Return

At the time of death, the decedent is treated as if they had lived the entire year. Their executor, administrator, or personal representative is responsible for filing a final Form 1040 (U.S. Individual Income Tax Return) covering January 1 through the date of death. Key considerations include:

  • Income Reporting: Wages, interest, dividends, retirement distributions, and other income received up to the date of death must be reported.
  • Joint Returns: If married, a joint return may be filed for the year of death, often reducing overall tax liability. The surviving spouse can generally file a joint tax return for the year of death, provided they do not remarry that same year. The joint return includes the deceased spouse’s income and deductions up to the date of death and the surviving spouse’s income and deductions for the entire year. 
  • Deductions and Credits: Standard or itemized deductions, as well as credits (such as child tax credits or earned income credits), are available on the final return if the decedent qualified. A surviving spouse can exclude up to $500,000 of capital gains from the sale of their primary residence if they sell the residence within two years of their spouse’s death. This is a special rule that allows the surviving spouse to use the same $500,000 exclusion amount available to a married couple filing jointly.

Income in Respect of a Decedent (IRD)

Certain types of income are not reported on the decedent’s final return but instead pass to heirs or the estate. This is known as Income in Respect of a Decedent (IRD) under Internal Revenue Code §691. It is income to which a person is entitled at death that was never taxed during the person’s life. Common examples include:

  • Retirement account distributions (IRA, 401(k), pensions not yet distributed). This includes any required minimum distribution (RMD) for the year of death that was not taken.
  • Accrued but unpaid vacation and sick time, interest, and dividends.
  • Gains from the sale of property (including stocks) if the sale was completed before death, but the proceeds were received after.
  • Deferred compensation, installment sale proceeds, or business receivables.
  • Accrued rent from real estate owned by the decedent.
  • Partner or shareholder’s share in business income up to the date of death.

IRD does not receive a step-up in basis and remains taxable to the recipient (estate or beneficiary). However, the estate tax attributable to IRD may be deductible.

The beneficiary who receives the IRD must report it as income for tax purposes in the year it is received. The IRD retains the same tax character it would have had for the decedent. For example, if the income were a long-term capital gain, it would be taxed as such to the beneficiary. 

Estate and Inheritance Taxes

The decedent’s property interests at death may be subject to federal estate tax and, in some jurisdictions, state estate or inheritance taxes.

  • Federal Estate Tax: As of 2025, the federal estate tax exemption is historically high (scheduled at $12.92 million per individual in 2023, indexed for inflation, but subject to legislative changes). Assets exceeding the exemption may be taxed at rates up to 40%.
  • State-Level Taxes: Several states impose their own estate or inheritance taxes, sometimes at much lower thresholds than the federal exemption.
  • Portability: A surviving spouse may elect portability of the decedent’s unused exemption (DSUEA) by timely filing of an estate tax return (Form 706).

Basis Adjustment of Assets

One of the most significant tax benefits at death is the step-up (or step-down) in basis:

  • Property included in the decedent’s estate generally receives a new basis equal to its fair market value at the date of death. This is why it is essential to have real and some personal property (stocks, for example) valued by appraisal or other methods as of the date of death.
  • This eliminates unrealized capital gains, potentially reducing income tax when beneficiaries later sell the property.
  • Special rules apply to community property states, where both halves of community property receive a step-up in basis.

Retirement Accounts and Tax-Deferred Assets

Retirement accounts require careful handling at death:

  • Traditional IRAs and 401(k)s: Beneficiaries must generally take distributions under the 10-year rule (post-2019 SECURE Act) unless they qualify as an eligible designated beneficiary (e.g., spouse, disabled beneficiary, minor child, or beneficiary not more than 10 years younger than the decedent).
  • Roth IRAs: An inherited Roth IRA provides tax-free withdrawals of the original owner’s contributions and potentially tax-free earnings if the account was held for five years or more before the owner’s death. Non-spouse beneficiaries must typically withdraw the entire account balance within 10 years of the original owner’s passing. Unlike traditional IRAs, spouse beneficiaries have special options, such as rolling the inherited Roth IRA into their own personal IRA, which exempts them from the 10-year rule. 
  • Spousal Options: A surviving spouse may roll over the decedent’s IRA into their own IRA, often deferring taxation.

Trust and Estate Income Tax (Form 1041)

If the estate or a trust receives income after the decedent’s death, the fiduciary must file Form 1041 (U.S. Income Tax Return for Estates and Trusts):

  • Taxable income may include dividends, rents, interest, or business income.
  • Beneficiaries receive a Schedule K-1 showing their share of income, deductions, and credits.
  • Proper allocation between estate and beneficiaries can reduce overall tax exposure.

Administrative Issues and Filing Deadlines

The executor or administrator must navigate multiple tax responsibilities:

  • Final Form 1040: Due April 15 of the year following death (an extension to October 15th is available by timely filing Form 4868).
  • Estate Tax Return (Form 706): Due nine months after death, with a six-month extension possible by timely filing Form 4768. Neither Form 706 nor 4768 can be e-filed. Most estates do not need to file Form 706. The filing requirement generally applies to the estates of U.S. citizens or residents with a gross estate value that exceeds the annual exemption amount.  The executor must also file a return if they are electing “portability,” which allows a surviving spouse to use any unused federal estate tax exemption from their deceased spouse.  For 2025, the exemption is $13.99 million per individual, and it is set to increase permanently to $15 million in 2026. 
  • Form 1041: Due on the 15th day of the fourth month following the estate’s year-end (calendar or fiscal year election allowed). If you need more time to file Form 1041, apply for an automatic 5-month extension. Submit Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns.

Failure to file timely can result in penalties, interest, and loss of tax elections such as portability.

Conclusion

Tax issues at the time of an account holder’s death are complex and intersect income, estate, and fiduciary tax regimes. Executors, administrators, and heirs must consider the decedent’s final tax obligations, the treatment of IRD, estate tax exposure, basis adjustments, and retirement account rules. Careful coordination between estate planning documents, state laws, and federal tax compliance ensures the estate and its beneficiaries minimize tax burdens and avoid costly errors. Professional guidance from tax practitioners, estate attorneys, and financial advisors is strongly recommended to navigate this critical period.