Do You Have to Pay Taxes on a Trust Inheritance?

Receiving an inheritance from a trust can feel like a financial windfall, but it also raises an important question: how much of it will the IRS want? Many beneficiaries are surprised to learn that the tax rules for trust inheritances are far from straightforward. Depending on how the trust was structured, what assets it holds and whether distributions are considered income or principal, your tax liability can vary dramatically.

A financial advisor can help you understand these rules and plan the best way to manage inherited trust assets.

How Trusts Work

A trust is simply a legally recognized collection of assets, including cash and physical holdings. The person who creates the trust is known as the grantor. A trust is overseen by a trustee. The trustee can be a person or a firm that manages the trust for the beneficiary.

The beneficiary of the trust is the person who benefits from these assets. This beneficiary can be an individual, such as a child or other relative, or an organization like a charitable group.

Trusts are often used as a tool to minimize estate taxes. Also, while assets transferred via a will usually have to go through the probate process, trusts can usually bypass that step, speeding up the process and saving on court fees.

Types of Trusts

Clients meeting with a financial advisor to discuss estate taxes.

There are quite a few types of trusts, but one of the biggest differences between trusts is whether they’re revocable or irrevocable. A revocable trust can be modified at any point during the lifetime of the person making the trust—also known as the grantor. The grantor can add or remove beneficiaries, add or remove assets from the trust or terminate the trust completely. Once the grantor dies, the trust then becomes set in stone and can no longer be changed.

On the other hand, an irrevocable trust is set in stone as soon as it’s finalized. The grantor can’t change the beneficiaries or the terms or remove any assets from the trust once it’s established. These are the two main categories of trusts, but there are many other types of trusts you might run into as well. These include:

Marital trusts
Bypass trusts
Charitable trusts
Generation-skipping trusts
Grantor-retained annuity trusts
Life insurance trusts
Special needs trusts
Spendthrift trusts
Testamentary trusts
Totten trusts

How Are Trusts Taxed?

Trusts are taxed based on whether their distributions are tied to principal or income. Principal distributions, or distributions taken from the money originally placed in the trust, are not taxed. Income distributions, at a high level, refer to the earnings generated by the assets held within the trust. These earnings include items such as interest, dividends, rents received, and capital gains. These are either taxed as income or as capital gains, depending on how they were earned.

There are four income tax brackets for trusts, 10%, 24%, 35% and 37%, unlike the seven tax brackets for individuals. Long-term capital gains are taxed at 0%, 15% or 20%, based on total gains.

Trusts and their beneficiaries will use IRS Form 1041 and a K-1 to file taxes. The K-1 will indicate how much of the distribution was income and how much was principal.

Another factor that governs how trusts are taxed is whether the trust is a grantor or non-grantor trust. Grantor trusts are set up so that the grantor pays taxes on income. Regarding non-grantor trusts, who pays taxes will depend on how the trust was set up. Trust accounting rules can be extremely complex, and your financial situation outside of the trust can come into play as well.

Tax Advantages and Drawbacks of Inheriting Through a Trust

One advantage of inheriting through a trust is that distributions of principal are not taxable. The IRS assumes the money placed in the trust was already taxed, so beneficiaries usually do not pay taxes on that part of a trust inheritance. This makes trusts a useful way to pass wealth without creating new tax obligations on the original assets.

Trusts can also provide some tax planning flexibility. A trustee may choose to distribute income in smaller amounts over several years to keep beneficiaries in lower tax brackets. Income can also be directed to beneficiaries who are in lower brackets than others, helping reduce the overall tax cost.

The drawback is that trusts face high income tax rates very quickly. A non-grantor trust reaches the top federal tax rate after only $16,000 of taxable income. By comparison, single individual taxpayers do not reach the highest tax bracket of 37% until their taxable income exceeds $640,600 in 2026. Leaving income to accumulate inside a non-grantor trust, rather than distributing it, can therefore result in a much larger tax bill.

Beneficiaries must also handle more complex reporting. Trusts issue IRS Schedule K-1 forms that show whether distributions came from interest, dividends, or capital gains. Beneficiaries then report each type of income on their personal tax return. This can make filing taxes more complicated, especially if the trust holds many investments.

What a Trust Inheritance Tax Might Look Like

A financial advisor creating an estate plan for a client.

Say you receive a $10,000 distribution one year. When the trust sends you the K-1, you see that $8,000 was from the principal. The IRS presumes this money was already taxed, so you don’t owe taxes on that amount. $1,000 was from interest earned, you will owe income tax on that amount. The final $1,000 was from selling stock for a profit, you will owe capital gains tax on that amount.

Let’s say you’re a single taxpayer with non-trust taxable income of $100,000. The $1,000 of interest income is taxed at ordinary tax rates, which for you is 22%. The $1,000 earned from selling stock is taxed at capital gains rates of 15% in your situation. In total, you will owe $370 on the $2,000 of taxable income distributed to you from the trust. This is a simple example, and as mentioned above, trust taxes can and often do get much more complicated. Work with the trustee or a personal financial advisor to make sure you’re getting the details right.

Bottom Line

Trust taxation comes down to one core distinction, principal versus income, but the details get complicated fast. Trust brackets compress much faster than individual brackets, and even a simple distribution can mean separating ordinary income from capital gains at different rates. Beneficiaries are typically taxed only on the earnings portion of what they receive, and whether the trust or the beneficiary owes that tax depends on how the trust was structured, worth confirming before assuming how a distribution will be taxed.

“Having a trust inherit assets can be beneficial for a number of tax and estate purposes. From a high level, distributions of trust principal are generally tax-free, whereas distributions related to income is taxable. Whether trust beneficiaries or the trust itself are responsible for paying the tax is dependent on the type of trust and numerous complex calculations. For that reason, it is highly encouraged that you seek the expertise of an estate attorney or tax professional with a thorough knowledge of trust taxation,” said Matthew Hofacre, MSPFP, CFP®, EA.

Matthew Hofacre, MSPFP, CFP®, EA provided the quote used in this article. Please note that Matthew is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinion voiced in the quote is for general information only and is not intended to provide specific advice or recommendations.

Tips for Estate Planning

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