Tax Consequences of Terminating an Irrevocable Trust

An irrevocable trust is a legal arrangement that cannot be changed or undone once it’s created. These trusts are often used to shield assets from creditors, provide long-term support for beneficiaries and reduce potential estate taxes. Still, situations can arise that justify bringing an irrevocable trust to an end, such as when its original objective has been met or the trust no longer holds meaningful assets. Ending an irrevocable trust can trigger several tax considerations, so it’s helpful to understand the financial consequences before doing so.

A financial advisor may help guide you through the estate planning process and assist in setting up an irrevocable trust.

What Happens When an Irrevocable Trust Is Dissolved?

Dissolving an irrevocable trust can be a complex process, usually requiring getting consent from all beneficiaries, filing the necessary paperwork and potentially getting court approval. In states like California, it’s necessary to file a petition to terminate the trust with the probate court.

Beneficiaries and trust assets can face notable repercussions when a trust is dissolved. For example, if the trust was designed to offer steady income, this income stream could get disrupted when the trust is terminated. Additionally, if the trust held assets that have substantially appreciated in value, this could carry significant tax implications when they’re distributed.

Potential Tax Consequences of Terminating an Irrevocable Trust

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When assets held within an irrevocable trust are liquidated and distributed to beneficiaries, those transactions may trigger a combination of income and capital gains taxes.

The tax liability associated with distributions will depend on whether the entity is a grantor trust or a non-grantor trust. With the former, the person who created the trust is considered the owner of the assets and is responsible for the taxes. A non-grantor trust, on the other hand, gets taxed as a separate entity. As a result, the trust itself and its beneficiaries are the ones who will pay the tax bill on the distributions.

Income Taxes

Irrevocable trusts often hold income-producing assets such as savings accounts, bonds or dividend-generating stocks. The earnings from these assets are taxed as ordinary income. It’s also worth noting that distributions of the trust’s principal aren’t taxable to the recipient; only the income and gains the trust produces can trigger an income-tax bill.

If an irrevocable non-grantor trust is wound down, any accumulated income is typically passed out to the beneficiaries, who then report and pay taxes on it. By contrast, when a grantor trust is terminated, the income tax burden stays with the individual who originally established the trust.

Capital Gains Taxes

Investment gains that build up inside an irrevocable trust are subject to capital gains tax once they’re realized. When the trust ends and those gains are distributed, beneficiaries pay tax based on their own applicable capital gains rate.

In 2026, assets that are sold after more than a year are taxed at the long-term capital gains tax rates of 0%, 15% or 20%. Short-term capital gains, which are the proceeds from the sale of assets held for less than a year, are taxed as ordinary income.

Estate Taxes

Placing assets in an irrevocable trust removes them from the grantor’s taxable estate. As a result, the value held in the trust generally isn’t counted when calculating estate taxes at the grantor’s death.

Keep in mind that only large estates worth more than $15 million are subject to the federal estate tax in 2026 (up from $13.99 million in 2025), so this tax is not something most people have to worry about. This has made irrevocable trusts a valuable estate planning tool for the wealthy, helping them minimize their estate tax liability.

In March 2023, the IRS clarified that assets held in an irrevocable grantor trust are not eligible for a step-up in basis at the grantor’s death. A step-up is only available when the property is included in the grantor’s gross estate and evaluated under federal estate tax rules. If dissolving the trust causes those assets to move back into the grantor’s taxable estate, the shift can create potential estate tax exposure for the estate and its beneficiaries.

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What to Consider Before Terminating the Trust

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Before pulling the plug on an irrevocable trust, it’s important to consider the potential tax consequences and other possible financial implications. Particularly for individuals in the high-income bracket, the potential tax consequences could be a deterrent to terminating a trust. If the trust holds significantly appreciated assets, such as real estate or vintage cars, the beneficiaries could face a hefty tax bill upon dissolution.

Immediate financial impacts are also worth considering. For example, beneficiaries may experience a loss of income from the trust if it’s terminated.

Alternatives to Terminating an Irrevocable Trust

Ending an irrevocable trust is not the only way to address changing circumstances. In many cases, making adjustments can provide more flexibility without triggering the tax consequences that come with dissolution.

Here are some alternatives to consider:

Trust decanting: Decanting allows a trustee to move assets from an existing trust into a new one with updated terms. This can modernize provisions, change distribution rules or relocate the trust to a state with more favorable laws. Decanting keeps the trust structure intact while addressing beneficiary needs more effectively.
Modification by consent: In some states, a trust can be modified if all beneficiaries agree. These changes may allow for updated distribution terms, expanded trustee powers or adjustments that reflect new family circumstances. This approach avoids a full termination and preserves the trust’s original benefits.
Court-approved changes: When consent among beneficiaries is not possible, a court may approve modifications if circumstances have shifted significantly since the trust was created. Courts typically weigh whether the changes align with the grantor’s original intent. This option is more formal but can provide flexibility when needed.
Change of situs: The situs, or legal home, of a trust can sometimes be changed to another state. Moving a trust may provide access to better creditor protections, longer trust durations or lower state income taxes. This option can make a trust more efficient without dissolving it.
Replacement of the trustee: If dissatisfaction with a trustee’s management is the main issue, replacing them may resolve concerns. Appointing a new trustee, whether an individual or a professional institution, can restore confidence without altering the trust’s structure.

Bottom Line

Terminating an irrevocable trust can have significant tax consequences, triggering a combination of income, capital gains and estate taxes. Understanding these implications is critical before deciding to dissolve a trust. In many cases, adapting an irrevocable trust is more practical than dissolving it altogether. Exploring alternatives can help beneficiaries and trustees find solutions that maintain the trust’s protections while better fitting current needs.

Estate Planning Tips

A financial advisor with estate planning expertise can help you make a plan for your assets for when you’re no longer around. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Estate planning is about more than simply making a plan for your money. Advance directives are legal documents that enable individuals to retain control over their health care decision if they become incapacitated. If they’re something you want to consider, be sure to read SmartAsset’s comprehensive guide on advance directives for health care.