The Death of a Spouse Is Hard. Taxes Make It Harder.

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Some survivors who need cash should sell a home within two years of a spouse’s death to get an exemption of $500,000 on the sale proceeds, not $250,000. Others will want to act quickly to convert traditional IRA assets to Roth IRAs in the year their spouse dies, when doing so can lower taxes on the conversion. Still others should check their withholding or estimated taxes if the spouse who died normally was responsible for making payments to the Internal Revenue Service. This will help avoid underpayment penalties at tax-filing time. This is a complex area, and learning about it can help with predeath as well as postdeath planning. Here are key issues to consider.

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Tax-bracket shifts

The year of death is the last for which a couple can file jointly. After that, the survivor files either as a single person or, if there are dependent children, as a surviving widow or widower. Surviving widow(er)s retain the benefits of joint filing for up to two years after the year of the spouse’s death, and then typically file as head of household. Beware the shift from joint filer to single filer. The survivor’s tax rate may stay the same or even rise while his or her income drops. Some call this “the widow’s penalty.”

For example, take a couple with $230,000 of taxable income and a top tax rate of 24% for 2020. If one spouse died last year and the survivor has $180,000 of taxable income this year, he or she will face a top tax rate of 32% for 2021 even with about 20% less income. Suggestion: consider accelerating income, such as from asset sales, while joint-filing rates and brackets are still available. If income drops in the year of death, say because of large medical-expense deductions, that could provide more room for acceleration.

The step-up

Under current law, the estate of someone who dies with assets held outside retirement accounts—such as a home, stocks, or a business—typically doesn’t owe tax on their appreciation. When heirs sell these assets, they owe tax only on growth after the original owner’s death. This valuable resetting of the cost basis, which is the starting point for measuring capital gains, is called the “step-up.”

The home-sellers’ exemption

Survivors who plan to sell their home should watch the calendar. Married joint filers get to skip tax on up to $500,000 of appreciation when they sell their home, and widows and widowers also get the $500,000 break if they haven’t remarried and sell within two years of the partner’s date of death. If they sell later, the exemption drops to $250,000, the amount for single filers.

Retirement accounts

Surviving spouses can roll over inherited retirement accounts such as 401(k)s and IRAs into their own names, and financial advisers routinely recommend this move. But it may not always be smart, if the survivor is under age 59 ½ and will need to draw on an account, then rolling it over could bring a 10% penalty on payouts. New widows and widowers should carefully consider their options. It’s possible to divide retirement accounts such as IRAs, and to roll over some but not all assets into the survivor’s name. This would leave the remainder in an inherited IRA available for penalty-free payouts to younger spouses.

More..

https://www.wsj.com/articles/taxes-after-death-of-a-spouse-irs-11635462166 (subscription)

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I would talk to an accountant.