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Estates and Trusts

Updated for Tax Year 2016


OVERVIEW

Did you receive a payment or other property from an estate or trust during the year? If so, here's what you need to know about how it affects your taxes


I am a beneficiary of my father's estate. I received a cash bequest of $50,000. Do I have to pay tax on it?

No, the cash your father left you in his will is tax-free.

My uncle left me $10,000 worth of stock. Is that taxable?

You don't owe tax when you inherit the stock. You might or might not owe tax when you sell the stock.

When you inherit stock, your "tax basis" in the securities -- that is, the value you use to determine your tax gain or loss -- is generally the value of the stock on the date of your uncle's death as noted in any estate or inheritance records. So you would owe capital gains tax only on the amount of any appreciation after your uncle's death. If the stock falls in value before you sell it, you would have a tax-saving capital loss.

I heard that all inheritances are tax-free. Is that correct?

In a word, no. Cash, stock and real estate are not taxed as income when you inherit them, but you could have taxable gains when you sell the stock or real estate--depending on the circumstances. Some other assets come with a tax string attached -- you're taxed on part or all of the value, just like the original owner would have been if he or she had lived. This rule comes into play for assets that have what's called "income in respect of a decedent."

Common examples of assets of this type are savings bonds, annuities, IRAs and other tax-favored retirement plan accounts such as 401(k) accounts. If you inherit savings bonds, for example, you'll owe tax on all interest that accrued during the life of the previous owner. If you inherit an annuity, the same portion of each payment will be taxable or tax-free as was true for the original owner. This same rule applies if you are the beneficiary of a traditional IRA, as discussed later.

I inherited some EE Savings Bonds from my mother's estate. Are the bonds fully taxable?

The principal on the bonds is tax-free, but you will owe income tax on some or all of the accrued interest.

If your mother was like most taxpayers and did not pay tax on the interest as it accrued each year, the executor of her estate can elect to have the estate pay income tax on the interest earned before your mother's death. If so, that wipes out your tax liability for that interest when you cash in the bonds.

On interest that accrues after her death, you have a choice of paying tax each year on the interest or postponing the tax bill until you cash in the bonds. If your mother's estate doesn't pay income tax on the interest, you have the same choice for all of the accrued interest on the bonds: Pay tax now or postpone the bill until you cash in the bonds.

If your mother paid tax each year as the interest accrued on the bonds, you only need to report the interest earned after her death.

My father died in 2016 at age 68. I was named as the beneficiary of his IRA. Is this a tax-free inheritance?

It depends. If it's a Roth IRA, the inheritance is federal-income-tax-free if the account was opened more than five years before you take any withdrawals.  If it's a traditional IRA, however, you will usually owe income tax as you withdraw money from the account. You have two choices on how to take withdrawals:

  • Begin taking annual withdrawals over your life expectancy by December 31 of the year after your father’s death (December 31, 2017 in this case), or
  • Clean out the account by the end of the fifth year after  the year of his death (December 31, 2021 in this case)

If you elect to use the life-expectancy method, you can stretch out the required withdrawals over a number of years  and leave what's left in the account at your death to your heirs, who would then owe tax as they withdraw the money.

My spouse died in 2016 at age 68 and I was the beneficiary of his traditional IRA. What are my options?

You have the same two withdrawal choices we just noted, plus a third option  that's only available to a beneficiary who is the spouse of the deceased IRA owner.

Under the third option,  you can elect to treat the IRA as your own IRA by rolling the money over to an existing IRA in your name or by re-titling the IRA to show you as the account owner (rather than the account beneficiary). By doing so, you won’t have to begin taking mandatory annual withdrawals from the IRA  until after you reach age 70½.

I inherited my mother's traditional IRA. Do I have to pay tax on the full amount I receive each year from the account?

Actually, when you inherit an IRA, there's an easily overlooked deduction.

If the estate was large enough to be subject to federal estate tax,you can deduct the portion of the federal estate tax attributable to the IRA.

In addition, you don’t have to pay tax on the portion of withdrawals attributable to nondeductible contributions that your mother made to the IRA (if any).

Here's an example:

Say you inherited a $50,000 IRA when your mother died in 2016, which, because it was included in your mother's taxable estate, boosted the estate tax bill by $22,500. Although you have to pay federal income tax as you pull the money out of the IRA, you also get an income tax deduction for that $22,500.

If you pulled the entire $50,000 out in 2016, you get the full deduction on your 2016 return. If you withdrew just $5,000 (one-tenth of the account), you deduct 10% of the estate tax bill attributable to the IRA. That’s $2,250 in this example.

This miscellaneous deduction for federal estate tax on "income in respect of a decedent" is taken on line 28 of Schedule A. It is not subject to the 2% rule that limits the deduction of most other miscellaneous expenses.

I set up a trust for my son. Do I have to file a tax return for the trust?

You must file a tax return for the trust depending on the type of trust established or if it is not required to distribute all of its income to your son each year, or if its gross income is $600 or more.

I received a form called a 1041 (K-1) for a trust my parents set up for my siblings and me. How does it affect my taxes?

If you are the beneficiary of a trust, you are responsible for paying tax on your share of the trust income that's distributed to you. The Schedule K-1 you receive details your share of the trust's income, deductions and credits, which you report on your tax return. The K-1 tells you where to report each item. TurboTax does this for you automatically.

How are trusts taxed for income tax purposes?

Trusts have their own income tax rate schedule for income the trustee chooses to retain rather than distribute to beneficiaries. To prevent trusts from being used as tax shelters,  higher tax rates kick in at much lower income levels  than for individuals.

For example, if a trust has undistributed taxable income of more than $2,550, it is in the 25% tax bracket in 2016. By contrast, married joint-filing couples  don't reach that tax bracket until they have more than $75,300 of taxable income, and single taxpayers need more than $37,650 of taxable income to be in the 25% bracket for 2016. Trusts reach the maximum 39.6% tax bracket with undistributed taxable income of more than $12,400 in 2016, while married joint-filing couples need to have more than $466,950 of taxable income to be taxed at the highest rate in 2016 ($233,475 for individuals who use married filing separate status).

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.


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