Q: Why would my accountant tell me that my inheritance would be subject to income tax? I thought it was only subject to inheritance tax.
A: Generally speaking, an inheritance is not subject to income tax. However, sometimes a distribution from an estate can include taxable income. It doesn’t happen often, but it does occur.
An estate, just like an individual, has to report income on an income tax return. Estates can earn income in a number of ways, but the most common way is from interest on the accounts it owns. The interest on an estate-owned account should be reported on the estate’s fiduciary income tax return.
Although estates have to report the income, they have the ability to distribute taxable income to heirs. When an estate makes a distribution, along with the inheritance, the distribution can include income. For example, assume that after an estate prepared its tax return, it had $1,000 of taxable income. Also assume the estate made a distribution to an heir in that tax year of $5,000.
What likely would happen is the distribution would be $4,000 of inheritance and $1,000 of income. The heir would receive an IRS form K-1 from the estate and have to pick that $1,000 up on his or her income tax return.
That may sound unfair, but honestly, it’s not a bad thing. Estates hit the top tax rates much quicker than individuals. An heir who picks up the income on their personal income tax return likely saves tax dollars in the long run.
Another common way beneficiaries may receive taxable income as a result of a decedent’s death is when they are named beneficiary of an asset that has tax-deferred income. Although technically not a distribution from an estate, a distribution from a tax-deferred account such as an IRA or annuity will result in the beneficiary having to recognize taxable income.
Same thing if a beneficiary is a joint owner on a tax-deferred savings bond. Liquidation will result in taxable income that needs to be recognized by the surviving joint owner.
Nobody likes to pay taxes. However, income distributions are sometimes par for the course. At least with the repeal of the Indiana Inheritance Tax, the hit might not be as bad as it could have been.
Opinions are solely the writer's. Christopher W. Yugo is a Crown Point attorney. Address questions to Yugo in care of The Times, 601 W. 45th Ave., Munster, IN, 46321 or to email@example.com. Yugo's information is meant to be general in nature. Specific legal, tax, or insurance questions should be referred to your attorney, accountant or estate-planning specialist.