This article was published in The Denver Post and written by Kevin McCormally
Because federal tax law reaches deep into all aspects of our lives, it's no surprise that the rules that affect us change as our lives change. This can present opportunities to save or create costly pitfalls to avoid. Being alert to the rolling changes that come at various life stages is the key to holding down your tax bill to the legal minimum. If you've experienced the loss of your spouse recently, know that the tax code has ways to help you at this difficult time.
If your spouse died this year, you may still file a joint return for the year. This gets you the most favorable tax rates and the largest standard deduction (if you don't itemize).
You may also claim a full exemption amount for your late husband or wife regardless of when during the year the death occurred. For the first two years after your spouse's death, you can file as a "qualifying widow or widower if you have a child living with you who qualifies as your dependent". This filing status also lets you use joint-return rates, but you don't get an exemption for your late spouse.
Starting in year three, if you have a dependent child living with you, you can claim head-of-household status, for which tax rates are less favorable that for joint return and qualifying widows and widowers, but better than the rates for single taxpayers.
The proceeds you receive from a life insurance policy are income tax-free. It doesn't matter whether your spouse paid the premiums or his or her employer paid for the policy. Don't report the proceeds as taxable income.
Widows and widowers get a special break when it comes to individual retirement accounts inherited from a spouse.
Non-spouse beneficiaries must begin taking withdrawals (based on their life expectancy) in the year following the death of the original owner, or clean out the account completely within five years. (This rule applies to both traditional and Roth IRAs.)
If your husband or wife named you the beneficiary of the IRA, however, you have another choice: You can claim the IRA as your own. If it's a traditional IRA, that means you would not be required to take minimum distributions until you reach age 70 1/2. If it's a Roth, you'd never have to take distributions.
In some cases, though, it might make sense to treat the account as an inherited IRA rather than your own... at least for a while. If you are younger than 59 1/2, you can withdraw funds from an inherited IRA without paying the 10% penalty for early withdrawals. (This penalty is often of little or no threat to Roth IRAs.) If you'll need some of the money in a traditional IRA before age 59 1/2, you could treat the IRA as an inherited account until you reach that age and then claim it as your own.
The tax basis of most of your assets you inherit from your spouse if stepped up to the property's value on the day he or she died. (The exception to this rule applies to retirement accounts.)
Since the basis is the amount from which gain or loss is figured when you sell the asset, this means that tax on any appreciation prior to the death is forgiven. Say, for example, that your husband had stock in a brokerage account for which he paid $10,000 but was worth $50,000 when he died. Your basis would be $50,000. Only if you sold the stock for more than that would you owe any capital gains tax. If you sold it for less than $50,000, in fact, you would have a tax-saving capital loss. If you and your spouse owned investments jointly, at least 50% of the basis is stepped up to the date-of-death value. If you live in a community-property state, 100% of the value may be stepped up.
If you inherit rental property from your spouse, note that the step-up in basis discussed above will increase the depreciation deductions you may claim on the property. The higher basis needs to be cranked into your calculations if you continue to rent the property. It will also reduce taxable capital gains when you sell the property.
Selling the Family Home
There's a special rule for widows and widowers who sell the family home within two years of the day their spouse died. Single homeowners can take up to $250,000 of profit on the sale of a home tax-free. For married couples, the maximum tax-free amount is doubled to $500,000. To qualify for this break, you must have owned and lived in the house for two of the five years leading up to the sale. But if you and your spouse met the ownership and use tests before his death, you get to use the full $500,000 exclusion if you sell within two years of your spouse's date of death. You may not need to rush to sell to protect the profit. The stepped-up basis rule discussed earlier would also limit the possible taxes on home-sale profit.
Property you inherit from your spouse is generally income tax-free. But there are major exceptions.
If you inherit or are named the beneficiary of a retirement account (such as an IRA or 401(k)), withdrawals will be taxed to you just as the money would have been taxed if your spouse were alive and withdrawing the cash. When a traditional IRA is involved, for example, withdrawals are fully taxable (except to the extent, if any, that your spouse had contributed after-tax dollars to the account). If it's a Roth IRA, however, withdrawals are generally tax-free. If you are the beneficiary of a commercial annuity purchased by your spouse, you'll owe tax on a portion of each payout- just as your spouse would have.