Estates and Trusts

I received a form called a 1041 (K-1) from my uncle's estate. Does that mean I owe extra taxes?

Maybe, but maybe not. It depends on what the K-1 shows. When someone dies, an estate is born to handle distribution of the person's property. If income is earned on an asset before it is passed on to the new owner, for example, someone has to pay tax on that income. The estate can pay the tax or, if it passes that income on to a beneficiary, the beneficiary pays the tax. That's the kind of income that's reported on a 1041 (K-1) form. The form is also used to report other kinds of income, deductions and credits that are passed through to a beneficiary to you report the correct amounts on your tax return. To make your task easier, Turbo Tax asks for these items in its interview. You do not include the 1041 (K-1) with your tax return when you file.

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 only owe tax when you sell the stock. But you get a nice tax break: Your "tax basis" in the securities—that is, the value from which you will determine your gain or loss—is the value of the stock on the date of your uncle's death. 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, in fact, you'd get to deduct a tax-saving capital loss.

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

No. While cash, stock or real estate are not taxed as income when you inherit them, 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 what's called "income in respect of a decedent." Common examples of inheritances of this type are savings bonds, annuities, IRAs and other retirement plans such as 401(k)s. 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 tax-free and the same portion taxable as if the original owner were receiving the payments.

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 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 the bonds are cashed. 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 2007. I was named as the beneficiary of his IRA. Is this a tax-free inheritance?

It depends. If it is a Roth IRA, the inheritance is tax-free. If it's a traditional IRA, however, you will owe income tax as you withdraw money from the account. You have two choices on how to do that:

• Begin taking withdrawals over your life expectancy by December 31 of the year after his death (December 31, 2008 in this case); or
• Clean out the account within five years after the end of the year of his death (December 31, 2012 in this case).

If you elect to use the life-expectancy method, you can stretch out the distributions and leave what's left in the account at your death to your heirs, who would owe tax as they withdraw the money.

My husband died and I was the beneficiary of his IRA. What are my options?

You have the same two withdrawal choices we just noted, plus one significant one that's only available to a beneficiary who is the spouse of the IRA owner. You can elect to treat the IRA as your own IRA, rolling the money over to an IRA in your name. By doing so, you can delay taking distributions from the IRA until you reach age 70-1/2.

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

Actually, there's an easily overlooked deduction when you inherit an IRA. If the estate was large enough to be subject to federal estate tax, you can deduct the portion of the federal estate tax attributable the IRA. For 2007, estate taxes kick in when an estate has assets of more than $2,000,000 that go to persons other than the surviving spouse.

Here's an example: Say you inherited a $50,000 IRA, which, because it was included in your mother's taxable estate, boosted the estate tax bill by $20,500. Although you have to pay tax as you pull the money out of the IRA, you also get an income tax deduction for that $20,500.

If you pulled the full $50,000 out in 2007, you get the full deduction on your 2007 return. If you withdrew just $5,000 (one-tenth of the account), you deduct 10% of the estate tax bill attributable to the IRA: $2,050 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 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) from the trustee of a trust my parents set up for my siblings and me. How does this 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. Turbo Tax does this for you automatically.

How are trusts taxed for income tax purposes?

Trusts have their own income tax rate schedule. To prevent trusts from being used to shelter large amounts of income, higher tax rates kick in far sooner than for individuals. For example, if a trust has undistributed taxable income of more than $2,150, it is in the 25% tax bracket in 2007. Joint filers don't reach that bracket until they have more than $63,700 of taxable income and singles need more than $31,850 of income to be in the 25% bracket. Trusts reach the 35% tax bracket with undistributed taxable income of more than $10,450, while individuals need to have more than $349,700 of taxable income to be taxed at the highest rate.

Updated for tax year 2007