how to find out if you are a beneficiary of a trust

This is Part 1 of a series on inheritance and taxes.

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A loved one has passed away, and you're an inheriting heir and maybe the estate executor or trustee to boot. What happens now tax-wise? Good question. This the first installment of our series covering the most important tax-related considerations for heirs when a loved one departs.

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If you are the executor

When a loved one (the decedent) passes away, someone must tackle the job of handling the resulting tax issues. That person may be identified in the decedent's will as the executor of the decedent's estate. If there's no will, the probate court will appoint an administrator. In either case, let's call the person who is holding the bag the executor to keep things simple. That person may be you. If so, please pay attention, because you're responsible for filing any necessary tax returns and arranging to pay any taxes.

Or you may be the trustee of a trust that was set up to avoid probate. If so, you need to pay attention too.

The final Form 1040

If your loved one was unmarried, the final Form 1040 covers the period from Jan. 1 through the date of death. The final return is prepared in the usual fashion. It's due on the standard date: 4/15/22 for someone who dies this year. You can extend the return for six months, to 10/17/22, by filing IRS Form 4868.

Year of death Form 1040 for surviving spouse

When there's a surviving spouse who remains unmarried as of the end of the year that includes the deceased spouse's date of death, a final joint Form 1040 can be filed, as if the deceased spouse were still alive. The final joint return includes the deceased spouse's income and deductions up to the time of death plus the surviving spouse's income and deductions for the entire year. Filing a joint return is usually beneficial, because it allows the surviving spouse to take advantage of the more taxpayer-friendly rates and rules that apply to married joint-filing couples.

If the surviving spouse remarries on or before Dec. 31 of the year that includes the deceased spouse's date of death, you must use married filing separate status for the deceased spouse's final Form 1040. The surviving spouse can file jointly with his or her new spouse.

Surviving spouse may be able to use joint rates for two more years

The tax-rate advantage of married joint-filer status is extended to a qualified widow or widower for the two years that follow the year that includes the deceased spouse's date of death.

To be a qualified widow/widower for the year, you must be unmarried as of the end of that year. You must also pay more than half the cost of maintaining a home that is the principal home for the entire year of a child of yours (including a step-child) who is your dependent for the year (meaning you paid for over half of his or her support). Finally, you must have been eligible to file a joint return with your deceased spouse for the year that included his or her date of death.

Revocable trust

To avoid probate, many individuals and married couples of means set up revocable trusts to hold valuable assets including real estate and financial accounts. These revocable trusts are often called living trusts or family trusts. For federal income tax purposes, they are classified as so-called grantor trusts. As long as the trust remains in revocable status, it's a grantor trust, and its existence is disregarded for federal income tax purposes. Therefore, the grantor, or grantors if the trust is for a married couple, are treated for tax purposes as if they still personally own the trust's assets. So, the grantor or grantor's tax returns are prepared in the usual fashion without regard to the revocable trust.

Unmarried decedent's revocable trust

When an unmarried individual passes away, his or her grantor trust becomes irrevocable. As such, the trust is now treated as a separate taxpayer that's subject to the federal income tax rules for trusts. This is an unfavorable development, because the tax rates on undistributed trust income quickly climb to the maximum 37% rate for ordinary income and short-term capital gains and the maximum 20% rate for long-term capital gains (LTCGs) and qualified dividends.

If the 3.8% net investment income tax also applies, the marginal federal rate on a trust's undistributed investment income and gains can be as high as 40.8%/23.8%. Ouch! To avoid this fate, get the income and gains out of the trust by either distributing them to the trust beneficiaries or by winding up the trust.

Married couple's revocable trust

When a revocable trust is set up by a married couple, the trust usually continues to exist as a grantor trust after the first spouse passes away–with the surviving spouse taking over as the sole trustee. In such case, the trust's existence continues to be disregarded for federal income tax purposes, and the surviving spouse's Form 1040 is prepared in the usual fashion without regard to the revocable trust.

However, when the surviving spouse passes away, the trust becomes an irrevocable trust. Then the trust is treated as a separate taxpayer with the unfavorable federal income tax consequences mentioned above — unless you get the income and gains out of the trust by either distributing them to the trust beneficiaries or by winding up the trust.

The 2021 federal income tax rate brackets for trusts are as follows:

Rate brackets for ordinary income

10% tax bracket: $0 to $2,650

Beginning of 24% bracket: $2,651

Beginning of 35% bracket: $9,551

Beginning of 37% bracket: $13,051

Rate brackets for LTCGs and dividends

0% tax bracket: $0 to $2,700

Beginning of 15% bracket: $2,701

Beginning of 20% bracket: $13,251

The bottom line

When an unmarried individual passes away, the important federal income tax considerations explained here apply.

When a married individual passes away, the surviving spouse can often step into relatively favorable federal income tax rules, subject to timing considerations.

If you are the estate executor in either scenario, you are responsible for handling tax matters. So, you may want to hire a professional to prepare returns and help you implement tax-saving strategies. You should probably also seek advice if you are the trustee of what is now an irrevocable trust that holds substantial assets. I'll cover more tax issues for heirs in next week's column. So please stay tuned.

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