What happens to a mutual fund investment when a fund owner dies is dependent upon the tax structure of the mutual fund. Many mutual funds are owned in retirement savings vehicles, such as Individual Retirement Accounts, 401k and 403b plans. Others are held in non-qualified, taxable accounts. There are different options to beneficiaries depending on which structure is owned.
All financial assets are included in the taxable estate upon the death of the owner. This means, based on 2011 IRS estate tax regulations, that estates with assets of $5 million or more pay 35 percent in federal transfer tax. This is an all-or-none threshold, with no transfer taxes paid on smaller estates. Regardless of whether the mutual fund is held in a qualified retirement savings plan or in a non-qualified plan, it is included in the taxable estate and counted toward the threshold.
Retirement Savings Accounts
Inheriting qualified retirement savings plans provides several options to beneficiaries. Distributions taken upon the death of the owner lead to a taxable income distribution in traditional, tax-deferred retirement plans. While there is nothing to prevent the estate taxes on the funds, there are options to reduce the immediate affect of income taxes. A surviving spouse can elect to continue the plan as her own. Other options for a spouse or non-spousal beneficiaries include the lump sum distribution, five-year distribution or the rollover beneficiary IRA. The lump sum distribution takes everything out and taxes it. The five-year distribution splits distributions into five year periods. The beneficiary IRA lets beneficiaries keep the IRA status, taking out only annual required minimum distributions based on the beneficiary's age. The last option is most tax effective. Roth IRAs do not affect income taxes, but still benefit from maintaining the tax free growth in beneficiary IRAs with minimum distributions required.
If you inherit a non-qualified mutual fund, there is no concern over income taxes. You can inherit the funds and keep them in tact for as long as you wish. There is an IRS provision allowing a step-up of the cost basis. Assume Grandpa purchased $10,000 worth of mutual funds that grew into $100,000 when he died, leaving it for Jane. If Jane sells the funds without a step up in cost basis, there is an immediate $90,000 capital gain. However, Jane instead uses fair market value at the time of Grandpa's death, $100,000. This means if the mutual fund goes down to $95,000 and Jane sells it, she realizes a capital loss. If the fund goes up, the difference between the $100,000 and the sell price is the gain.
Whether mutual funds are liquidated immediately after the owner's death is based on several considerations. Of course, beneficiaries are interested in reducing tax implications. However, if the estate doesn't have enough to cover lingering debts or estate tax liabilities, there might be no other choice but to liquidate all mutual funds to pay everything off.