Email FacebookTwitterMenu burgerClose thin

Are Trust Distributions Taxable?

Form 1041 reports income generated by a trust.

Dealing with trusts and their tax implications can seem like a labyrinth of legal terms and financial jargon. Trust distributions might be taxable, with the tax liability potentially varying based on factors such as the type of trust, the kind of distributions, and a beneficiary’s tax bracket. With the help of a capable financial advisor, you can not only manage these complexities yourself but also better understand them. 

How Trusts Work

Trusts are intricate legal arrangements used for various financial and estate planning purposes. At their core, trusts involve three key roles: the grantor (the person who creates the trust), the trustee (who manages the trust assets) and the beneficiary (the one who benefits from the trust).

Trusts operate by transferring ownership of assets from the grantor to the trust itself. This separation of legal ownership from beneficial ownership allows for specific instructions regarding the use and distribution of these assets. The trustee holds the responsibility to manage and administer the trust according to the grantor’s wishes.

In essence, trusts offer control, privacy and tax benefits, making them valuable tools in financial and estate planning. By understanding how trusts work, individuals can make informed decisions to protect and manage their assets efficiently.

There are two primary trust types: revocable and irrevocable.

Revocable Trusts

Think of revocable trusts as living, adjustable trusts that the grantor can alter or cancel anytime in their lifetime. They help avoid the probate process – the legal means of validating a will that can be time-consuming and expensive. However, they don’t provide as many tax benefits as their counterparts, irrevocable trusts.

Irrevocable Trusts

Irrevocable trusts, on the other hand, are more of a locked box. Once established, they can’t be changed or ended without the beneficiary’s consent, allowing for more significant asset protection and superior tax benefits. Not considered part of the grantor’s taxable estate, irrevocable trusts can be a potent tool in reducing an estate’s tax liabilities and shielding assets from creditors.

What Qualifies as a Trust Distribution?

Trust distributions are essentially assets or income that get passed from the trust to beneficiaries. Distributions can be cash, stocks, real estate and other assets. If a trust owns a rental property, the monthly rental income the property generates would be distributed to the trust’s beneficiaries.

Do Beneficiaries Pay Taxes on Trust Distributions? 

A married couple signs off on documents creating a trust for their grandchildren.

In general, beneficiaries typically do not pay taxes on distributions from the principal of a trust. This means that if you receive a distribution from the trust’s principal, it is usually not considered taxable income for you. The trust itself, however, may owe taxes on any income it generates, such as interest, dividends, or rental income. These taxes are typically paid by the trust before distributions are made to beneficiaries.

Where it can get a bit more intricate is when beneficiaries receive distributions of trust income. In many cases, this income is taxable to the beneficiaries at their individual tax rates. It’s important to note that some trusts, like charitable remainder trusts, can provide beneficiaries with certain tax advantages, so it’s advisable to consult a tax professional to understand your specific situation.

Tax Benefits of Trust Distributions

One might observe that effective structuring of trust distributions could potentially offer tax advantages. First and foremost, trust distributions allow for income splitting among beneficiaries. By allocating income to beneficiaries in lower tax brackets, you can effectively reduce the overall tax liability of the trust. This can be especially advantageous in cases where the trust generates significant income.

Although not directly related to trust distributions, the weight of estate tax liabilities can also be reduced by gradually moving wealth from the grantor’s taxable estate into a trust. 

Furthermore, charitable remainder trusts can provide a unique advantage by allowing individuals to donate appreciated assets to a charitable trust. This strategy can result in a charitable deduction while also eliminating the capital gains tax on the donated assets. It’s a win-win situation, as it supports a charitable cause while reducing tax obligations.

Types of Taxes You May Pay Due to a Trust

A woman signs paperwork creating a trust for her children.

You might encounter several types of taxes due to trusts and their distributions. Here’s a look at the five tax variations you should understand as a trust beneficiary or trustee:

Ordinary Income Tax

Trusts often generate income from various sources, such as rental properties, interest and dividends. This income may be subject to ordinary income tax, which is typically levied on the trust’s earnings. If the trust holds on to that income, it pays the income taxes on it; if the trust distributes that income, the beneficiaries pay the income taxes on it.

The tax rate can vary depending on the trust’s structure and the amount of income it generates. While trustees are responsible for reporting and paying this tax on behalf of the trust, beneficiaries are liable if they receive distributions from this income. 

Keep in mind that trusts are subject to different income tax brackets than individuals. Trust taxes are higher than individual taxes. In 2023, the income tax brackets for trusts are: 

  • $0 – $2,900: 10%
  • $2,901 – $10,550: 24%
  • $10,551 – $14,450: 35%
  • $14,451+: 37%

Capital Gains Tax

When assets held within a trust are sold or transferred, any resulting capital gains may be subject to capital gains tax. The tax rate on capital gains vary based on several factors, including the type of asset and the duration it was held within the trust. Properly managing capital gains can help minimize the tax impact.

There are three tax brackets for long-term capital gains xrealized by trusts:

  • $0 – $3,000: 0%
  • $3,001 – $14,649: 15%
  • $14,650+: 20%

Gift Tax

Trusts can also be used for gifting purposes. If you establish a trust to gift assets to beneficiaries, you may encounter gift tax considerations. The Gift Tax applies when the total value of gifts exceeds the annual exclusion amount, which is $17,000 per recipient per year, as of 2023. It’s crucial to be aware of these limits to avoid unexpected tax liabilities.

Estate Tax

Estate tax is a tax imposed on the transfer of assets when a person dies. When assets are held within a trust, they may still be subject to estate tax, depending on the trust’s structure and the overall value of the estate. In 2023, estates worth more than $12.92 million are subject to the federal estate tax.

Property Tax

In some cases, trusts may hold real estate properties. Property tax is levied by local governments on the assessed value of real estate. Trustees must be aware of their obligations to pay property taxes on trust-owned properties to avoid penalties and legal complications.

Bottom Line

Grasping how trusts and trust distributions are taxed is crucial for trustees and beneficiaries, alike. When properly configured, a trust can provide financial security, protect assets and potentially offer significant tax benefits. Understanding the types of taxes associated with trusts, such as ordinary income tax, capital gains tax, gift tax, estate tax and property tax, is crucial for effective estate planning.

Estate Planning Tips

  • The IRS announced in March 2023 that assets held in an irrevocable trust won’t receive the step-up in basis if they aren’t included in the grantor’s taxable estate at the time of their death. Without the step-up in basis, the value of an asset doesn’t automatically jump to the current market value, increasing the eventual tax liability. 
  • A financial advisor with estate planning expertise can be a valuable resource in this often complicated process. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.

Photo credit: ©, ©, © Trade Latin