When inheriting mutual funds, the tax implications can be complex. Properly accounting for inherited mutual funds requires understanding cost basis adjustments, tax reporting on Form 1099-B, and correctly filling out Form 8949 for capital gains or losses. I’ll walk you through the key concepts, calculations, and IRS reporting requirements to ensure compliance and minimize tax liability.
Table of Contents
1. How Inherited Mutual Funds Are Taxed
Inherited mutual funds receive a step-up in cost basis to their fair market value (FMV) on the date of the original owner’s death. This means that if you sell the inherited shares, you only owe capital gains tax on the appreciation after the inheritance date—not the original purchase price.
Example: Step-Up in Basis Calculation
Suppose you inherit mutual fund shares originally purchased for \$20,000 but valued at \$50,000 on the date of death. If you later sell them for \$55,000, your taxable gain is:
\text{Capital Gain} = \$55,000 - \$50,000 = \$5,000Without the step-up, the gain would have been \$35,000.
2. Understanding Form 1099-B for Inherited Mutual Funds
Brokerages issue Form 1099-B when you sell inherited mutual funds. However, the reported cost basis may be incorrect because:
- The brokerage might not have the updated step-up basis.
- The form may show the original purchase price instead of FMV at death.
What to check on Form 1099-B:
- Box 1d (Cost Basis): Verify if it reflects the stepped-up value.
- Box 2 (Date Acquired): Should say “Inherited” or the date of death.
- Box 3 (Wash Sale): Usually blank unless disallowed losses apply.
Table 1: Common Form 1099-B Errors & Corrections
| Box on 1099-B | Potential Issue | How to Fix |
|---|---|---|
| 1d (Cost Basis) | Shows original purchase price | Manually adjust to FMV at death |
| 2 (Date Acquired) | Lists original purchase date | Report as “Inherited” on Form 8949 |
| 1e (Proceeds) | Incorrect due to partial sale | Verify sale amount with brokerage statement |
3. Reporting Sales on Form 8949 and Schedule D
If the cost basis on Form 1099-B is wrong, you must correct it on Form 8949 before transferring totals to Schedule D. Here’s how:
Step-by-Step Form 8949 Filing
- Part I (Short-Term) or Part II (Long-Term): Inherited mutual funds are usually long-term, regardless of holding period.
- Column (b) Description: List the mutual fund name and “Inherited.”
- Column (c) Date Acquired: Enter “Inherited” or the death date.
- Column (d) Date Sold: The actual sale date.
- Column (e) Proceeds: From Box 1e on Form 1099-B.
- Column (f) Cost Basis: Adjusted to FMV at death, not Box 1d.
- Column (g) Adjustment Code: Use “B” if basis was incorrect on 1099-B.
- Column (h) Gain/Loss: Calculated as \text{Proceeds} - \text{Adjusted Basis}.
Example: Form 8949 Entry
| Description | Date Acquired | Date Sold | Proceeds | Cost Basis | Adjustment | Gain/Loss |
|---|---|---|---|---|---|---|
| ABC Mutual Fund (Inherited) | 05/15/2023 | 10/20/2023 | \$55,000 | \$50,000 | Code B | \$5,000 |
4. Tax Rates on Inherited Mutual Fund Sales
Capital gains from inherited mutual funds are taxed at long-term rates, even if sold immediately. For 2024, the rates are:
Table 2: 2024 Long-Term Capital Gains Tax Rates
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | Up to \$47,025 | \$47,026-\$518,900 | Over \$518,900 |
| Married Filing Jointly | Up to \$94,050 | \$94,051-\$583,750 | Over \$583,750 |
Example Tax Calculation:
- If you’re single with \$60,000 taxable income and a \$5,000 gain:
- The first \$47,025 is taxed at 0%.
- The remaining \$12,975 (including \$5,000 gain) falls into the 15% bracket.
- Tax owed: \$5,000 \times 0.15 = \$750.
5. Common Mistakes & How to Avoid Them
- Not Adjusting Cost Basis: Always verify the step-up basis—brokerages often report the original purchase price.
- Incorrect Holding Period: Inherited assets are automatically long-term, even if sold within a year.
- Missing Form 8949: If the 1099-B basis is wrong, you must file Form 8949 to correct it.
6. Final Thoughts
Properly accounting for inherited mutual funds ensures accurate tax reporting and minimizes unnecessary liabilities. Always double-check Form 1099-B, adjust the cost basis, and correctly fill out Form 8949 to avoid IRS scrutiny. If in doubt, consult a tax professional specializing in inheritance tax matters.
