If a deceased family member would normally have been required to file a return for the year in which he or she died, a return must be filed on his or her behalf. Any income earned between the beginning of the year and the date of death should be reported on your family member’s final tax return.
To ensure that all income that your family member earns is accounted for, a legal entity called an estate is automatically created at the time of death. Income received after the date of death -- including income earned from bank accounts or stock while the estate is in probate -- should be reported on the estate income tax return, Form 1041.
Many assets that list a beneficiary, such as a life insurance policy or a brokerage account, can bypass probate and be paid directly to the beneficiary. Although the money paid out from assets that bypass probate are generally not taxable, any interest earned on these assets after the death of your family member is. And because the asset is being paid directly to the beneficiary, any interest earned by the asset before it’s paid out that is not properly reported on the decedent’s return is considered income in respect of a decedent (IRD) and to the beneficiary who receives it. This means that the beneficiary is responsible for reporting the income on his or her own tax return. Amounts paid from an inherited IRA, retirement plan, annuity, and certain other assets are also IRD to the extent that the decedent would have paid tax on the income had he or she received it.
Example: Peter dies on April 15, 2010, and owns several assets: a house that he is sole owner of, a cottage that he co-owns with his sister Jane, bank accounts "payable on death" to his sister, a mutual fund account, and a life insurance policy listing his sister as the beneficiary. The income earned from these assets should be reported as follows:
On Peter’s tax return: Income earned from his bank accounts and mutual fund until the date of death
On the estate income tax return: Income from the mutual fund earned after Peter’s death and income from the sale of the house.
On Jane’s tax return: The cottage, bank accounts, and money paid out from Peter’s life insurance policy go directly to Jane without probate. Any interest earned on the bank accounts and life insurance policy after Peter’s death should be reported on the return that Jane files. Although the money paid out from the life insurance policy is not taxable, any interest earned on the policy before it was paid to Jane is. If Jane decides to sell the cottage, the income from its sale should be reported on her return as well.
If a family member dies before filing a tax return for 2010, the spouse or personal representative may have to file and sign a return for that family member. A personal representative can be an executor, administrator, or anyone who is in charge of the deceased family member’s property. If the deceased family member does not need to file a return but had tax withheld, a return must be filed to get a refund. Whoever files the return must enter "Deceased," the deceased taxpayer’s name, and the date of death across the top of the return. If this information isn't provided, it may delay the processing of the return.
If your spouse died in 2010 and you didn’t remarry in 2010, or if your spouse died in 2011 before filing a return for 2010, you can file a joint return. Your joint return should show your spouse's income for the tax year earned until the date of death and your income for all of 2010. Enter "Filing as surviving spouse" in the area where you sign the return. If someone other than the surviving spouse is the personal representative, he or she must also sign.
You or the personal representative should also promptly notify all payers of income, including financial institutions, of your family member’s death. This will ensure that income earned by your family member’s estate or heirs is properly reported. You should not use your deceased family member’s Social Security number after the year of death. If an estate income tax return is required, the estate will need to request its own EIN to use for filing purposes.
If the family member who died was a dependent and lived in your home for the time he or she was alive, you can still claim that person as a dependent for the year -- as long as all the requirements to qualify as a dependent apply. In addition, if the deceased dependent was the person who qualified you to file as head of household or qualifying widow(er), or made you eligible for certain tax deductions or credits, these benefits are still available to you in the year of death.