Do I Owe Taxes on Mutual Fund Proceeds Received From the Death of My Father?
Mutual funds are commonly used to grow a person's living estate. They can be purchased in taxable or tax-deferred structures. General brokerage accounts are taxable while retirement savings accounts are tax-deferred. The tax liabilities, when inheriting your father's mutual funds, depend on which of the two tax structures the funds were held in.
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Determining Account Type
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A taxable brokerage account is any brokerage account that is not given IRS qualified retirement plan designation. You can determine if the inherited account is a taxable one by looking at the title registration on the statement. Anything that is titled with the deceased's name or trust is taxable. All retirement savings accounts have the custodian's name listed in the title along with the owner's. If you are still unsure after reading the account title, call the financial services firm to determine the account structure so you can properly address any tax liabilities.
Taxable Accounts
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Inheriting a taxable mutual fund works the same way as inheriting other securities, such as stocks and bonds. The entire account value at the time of the owner's death is added to the overall estate value. As of 2011, estates with more than $5 million in assets have a 35 percent federal transfer tax rate. That is just the federal estate tax. Each state has different state transfer requirements. As far as the inherited asset, the beneficiary may choose to either liquidate or keep the mutual fund. Either way, the cost basis for the beneficiary becomes an adjusted cost basis, meaning the fair market value of the mutual fund on the day of the owner's death is the cost basis. This can reduce capital gains; rather than pay gains on a mutual fund that was bought at $10 per share and sold for $20 immediately after death, the $20 is the stepped up cost basis.
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Qualified Plan Inheritance
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If the mutual fund is inherited through a qualified retirement plan, such as a 401(k) or IRA, the value is again added to the entire estate value for transfer tax purposes. The beneficiary has the option to take a lump sum distribution, a five-year distribution or roll over the assets into a beneficiary IRA. A surviving spouse has one more option, which is to continue the IRA as if it were her own. Whichever option is taken, when money is taken out of the qualified plan, it is added to income. There is no adjusted cost basis since capital gains are not an issue. Distributions are treated strictly as income.
Considerations
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Stretching an IRA refers to taking inherited distributions over more than one year. It is important to look at all opportunities to stretch distributions to reduce taxes while closing an estate. Assume you had $1 million in an IRA included in a $5 million estate. A lump-sum distribution will erode the IRA's value to less than $251,000. Choosing to defer distributions over five years or through lifetime requirement minimum distributions in a beneficiary IRA allows the assets to continue to grow and reduces the annual income tax burden. Eventually, Uncle Sam will get his share, but it gives beneficiaries more control over the estate.
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