When a mutual fund investor dies, the Internal Revenue Service will probably have the opportunity to collect taxes. Mutual funds don't stop throwing off taxable income just because a shareholder dies, and their transfer can also create tax liability. When they're held in tax-advantaged accounts, that can complicate matters as well.
Until the decedent's estate is closed out, it's still responsible for paying income tax on any income that is made. Income mutual funds, bond funds and other funds that pay dividends generate taxable income that will need to be reported on the decedent's final tax return, as well as on any subsequent estate tax returns. The estate's executor can use the estate's funds to pay any taxes that are due.
When someone dies, her estate is subject to estate tax if it exceeds the exclusion amount established by the IRS. For the 2013 tax year, every estate gets to exclude $5.25 million, so as long as the decedent hasn't given any gifts above the annual gift tax exclusion, no estate tax is due on assets, including mutual funds, which are $5.25 million or less. To calculate the value of the estate, everything it owns, including shares of mutual funds, has its value adjusted to what it would have been on the day that the decedent passed away. For instance, if the decedent had 1,000 shares of a mutual fund that originally cost her $15 per share and it traded at $45.50 on the day she died, her estate would assign a value of $45,500 to the shares.
Capital Gains Tax
When a mutual fund owner dies, the basis on her holdings gets adjusted to their value as of the date of death. However, this isn't a free pass from taxes. Once the value of the shares gets reset, they're subject to capital gains taxes relative to the new basis. For example, if a decedent pays $20 per share and dies on a day that the fund closes at $28, the basis will be $28. If, a year later, the person who inherits the shares sells them for $35, he'll be responsible for capital gains tax on the $7 profit over the $28-per-share adjusted basis.
IRA Taxation Considerations
Mutual funds in individual retirement accounts are taxed specially in an estate. For estate purposes, they're valued at the share price on the date of death. Inheritors of IRAs have very limited options for what they can do. Generally, beneficiaries have to start withdrawing from the account, and paying taxes on the withdrawals if they come from a traditional IRA, but they can spread the withdrawals over their life expectancy. When the IRA stays in the estate, it has to be drawn down over a five year period, though.
When a married person dies, transferring mutual funds is simpler. Barring a will or trust that specifies otherwise, the ownership of the account passes to the spouse. If it's an IRA, the spouse can roll the funds over into his own IRA if he wants. Furthermore, spouses get to double up the estate tax limitation, so when the second spouse dies, he can pass as much as $10.5 million, as of 2013, to his heirs tax-free if the first spouse didn't use any of her gift tax exclusion.
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