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I'm trying to figure out, if my wife inherits money through a by-pass trust, whether that will affect our income taxes during the period between the death of one parent and the death of the second.

My little understanding of these trusts is that, to optimize inheritance tax exemptions, a trust is set up in such a way that when one of her parents dies, my wife "inherits," but actually the second parent has full use of the trust during his or her lifetime. I also understand that the trust pays taxes on income generated by the trust.

But does that income from the trust count towards our income, even though my wife can't use it? What about after both parents die, if the money remains in a trust, or trusts?

Thanks.
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The trust income can be distributed to the widowed spouse and is then taxed on their 1040; or it can be retained in the trust and taxed on the trust's 1041, or it possibly can be distributed to your wife, definitely after the second death, but possibly before, to be taxed on her 1040.

She need not "get" the money to be taxed on it, but if it is "credited" to her she'll eventually get it after the first of the next year, or as a "previously taxed capital distribution". The trustee should be able to tell her what's happening. ed
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My little understanding of these trusts is that, to optimize inheritance tax exemptions, a trust is set up in such a way that when one of her parents dies, my wife "inherits," but actually the second parent has full use of the trust during his or her lifetime.

In most of these trusts I've seen, your wife would not inherit anything at the death of one of her parents. The money is usually put into a trust where the income is to the benefit of the surviving parent, but the children are the ultimate beneficiaries of the principal. So your wife would not have any claim on the trust until both of her parents pass away, and there would be no effect on her taxes until then.

However, each trust is unique. As difficult as it is, she probably needs to talk to her parents about the specifics of their trust. It's especially important if she is named as a successor trustee.

I'm trying to figure out, if my wife inherits money through a by-pass trust, whether that will affect our income taxes during the period between the death of one parent and the death of the second.

So to answer your initial question more directly, in most cases the trust would not affect your wife's taxes until the second parent passes away. However, you need to read the specifics of this trust to make sure that is the case here.

--Peter
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