Transforming growth factor beta (TGFbeta) receptors require SARA for phosphorylation of the downstream transducing Smad proteins. SARA, a FYVE finger protein, binds to membrane lipids suggesting that activated receptors may interact with downstream signaling molecules at discrete endocytic locations. In the present study, we reveal a critical role for the early endocytic compartment in regulating Smad-dependent signaling. Not only is SARA localized on early endosomes, but also its minimal FYVE finger sequence is sufficient for early endosomal targeting. Expression of a SARA mutant protein lacking the FYVE finger inhibits downstream activin A signaling in endothelial cells. Moreover, a dominant-negative mutant of Rab5, a crucial protein for early endosome dynamics, causes phosphorylation and nuclear translocation of Smads leading to constitutive (i.e. ligand independent) transcriptional activation of a Smad-dependent promoter in endothelial cells. As inhibition of endocytosis using the K44A negative mutant of dynamin and RN-tre did not lead to activation of Smad-dependent transcription, the effects of the dominant-negative Rab5 are likely to be a consequence of altered membrane trafficking of constitutively formed TGFbeta/activin type I/II receptor complexes at the level of early endosomes. The results suggest an important interconnection between early endosomal dynamics and TGFbeta/activin signal transduction pathways.