Important considerations when receiving an inheritance from a spouse

Losing a spouse is hard for many reasons. Understanding what happens next from a legal and financial perspective during a time of grief may feel impossible. Parts I and II of this series discussed the general implications and considerations to keep in mind when receiving an inheritance and when it may make sense to reject a gift. This article is the final part of this series on considerations when inheriting property and focuses specifically on inheriting property from a spouse. (While this article focuses on what happens after a spouse dies, this shouldn’t overshadow the importance of having an up-to-date estate plan before that time.)

Part 3: receiving an inheritance from a spouse

Common goals of estate planning for spouses

Estate planning is a crucial step for married couples to ensure their wishes are carried out, their loved ones are protected, and their assets are distributed according to their desires. Here are some common financial goals of this planning: 

• Guaranteeing financial security for the surviving spouse.
• Reducing or eliminating the impact of estate taxes upon the first spouse’s death.
• Ensuring assets are ultimately passed on to desired beneficiaries.
• Minimizing family conflicts and disputes by outlining plans in advance.

There are a number of concepts that impact how these goals are accomplished (and that help a survivor understand how inheriting property from a spouse works). 

Who owns the property? Community and separate property considerations

A spouse who dies can only control the property they own. In many states, property a spouse earns or acquires during marriage belongs to them alone, subject to certain rules about sharing with a spouse upon death or divorce. In community property states like California, spouses equally own property earned or acquired with earnings during marriage (“community property”) subject to certain exceptions for gifts, inheritances, or property owned prior to marriage (known as "separate property'”). While each community property state has slightly different rules about what constitutes separate and community property, they all provide that when a married person dies, the deceased spouse controls what happens to their half of community property and their separate property, while the surviving spouse controls what happens to their half of the community property and their separate property. Of course, any default rules about community property or separate property may be modified by a couple’s premarital or postmarital agreement.  

Default inheritance rules

As noted above, a surviving spouse in a community property state like California retains complete control of their share of community and separate property. This is often a great relief to a survivor facing an uncertain future. The next step is to determine what happens to the deceased spouse’s share of community and separate property. If the deceased spouse had planning in place (such as a will, trust, or beneficiary designations), this will determine who inherits the deceased spouse’s assets. In the absence of planning, California’s default rules provide that a surviving spouse inherits 100% of their deceased spouse’s community property and one-half to one-third of the deceased spouse’s separate property depending upon how many children or other close relatives the deceased spouse had.

Tax implications of inheritance

Part I of this series covered the general implications of receiving an inheritance. A survivor inheriting assets from a deceased spouse may have additional concerns, particularly if the family unit has been living on the deceased spouse’s income or assets. The good news is that there are favorable tax provisions in place to prevent income and estate taxes from impacting the surviving spouse. For example, a surviving spouse who inherits retirement accounts can typically complete a “spousal rollover” to treat the retirement funds as their own, retaining favorable income tax deferral over their own lifetime. Similarly, estate tax, which applies only to a deceased spouse whose property exceeds their estate tax exemption amount ($13,610,000 in 2024, but scheduled to decrease by 50% in 2026), may be deferred until the surviving spouse dies through an Internal Revenue Code provision referred to as the unlimited marital deduction.

The marital deduction

The unlimited marital deduction allows US citizen spouses to transfer funds between one another (during life and at death) so long as the gifts are properly structured. The goal of the unlimited marital deduction is to postpone, rather than avoid, gift and estate tax, and the specific rules surrounding the deduction are designed to ensure that the US government can collect estate tax at the time of the second spouse’s death if the assets are not consumed by the survivor during their lifetime. (There are deferral options when a surviving spouse is not a US citizen, but they require additional technical planning, which is not covered in detail here).

Gifts that qualify for the unlimited marital deduction can go to a surviving spouse outright (meaning they have total control) or can be made to a properly structured trust for the benefit of the survivor during their lifetime. The most common of these trusts is known as a QTIP trust. Not a small stick with a ball of cotton at each end, QTIP is an acronym for “qualified terminable interest property” and refers to a tax election that accomplishes the structure needed to qualify certain trusts for the marital deduction. QTIP trusts are popular because they allow a deceased spouse to provide for the surviving spouse’s care and financial security, postpone estate tax, and retain control over how the property is eventually distributed when the survivor later dies.

When a survivor discovers they are the beneficiary of a QTIP trust, this is what they need to know:

1. The trust must pay all income to the surviving spouse at least annually;
2. No trust property may be distributed to anyone other than the surviving spouse during the survivor’s lifetime; and
3. An estate tax return must be filed for the deceased spouse (even if not otherwise required) to make a QTIP election.
4. Who manages the QTIP trust, and what level of control the survivor has, are pre-determined by the deceased spouse’ estate plan.
5.  When the surviving spouse’s dies, assets remaining in the QTIP trust are included in the survivor’s taxable estate and may at that time be subject to estate tax if estate tax exemption is not available to shield the funds.

Portability of estate tax exemption

Prior to 2013, when a deceased spouse died and left assets to a surviving spouse outright, there was no way to preserve the deceased spouse’s estate tax exemption amount (the amount that the deceased spouse could gift free of estate tax). Consequently, married couples had to use special trusts (often referred to as “bypass” or “exemption” trusts) to accomplish this goal. At the beginning of 2013, Congress permanently allowed a deceased spouse to transfer or “port” their unused estate tax exemption amount to their surviving spouse. This is referred to as portability.

Portability provides significant flexibility to married couples in estate planning. This means that even a deceased spouse who has done no estate planning doesn’t have to forfeit their estate tax exemption amount if it could benefit the surviving spouse or family. Just like the QTIP election, portability is only available to the surviving spouse if the deceased spouse’s estate files a federal estate tax return. There are technical rules about how ported estate tax exemption is used, and it may be lost if the survivor remarries. It is critical for a survivor to seek advice about marital deduction and portability planning soon after losing a spouse so that the best decision can be made about how to proceed.

Timing and decision-making

Losing a spouse is never easy, and understanding the financial implications of inheritance can be complex and confusing. The good news is that there are often steps a survivor can take to set themselves up for maximum advantage financially going forward. Many of these steps require fairly swift action (the nine month anniversary of the deceased spouse’s death is a critical deadline), and analysis of the options and choices that are best for the family can take time. It is crucial to consult with financial and legal advisors as soon as possible after the first spouse’s death to evaluate these options and make decisions. We are here to provide support and guidance to those who would like to explore tax-efficient options for marital estate planning as well as assisting surviving spouses with making decisions regarding the deceased spouse’s estate.