Are Taxes on an Inheritance Going to Cost Me a Fortune? (2024)

Hilary Collins

·5 min read

Are Taxes on an Inheritance Going to Cost Me a Fortune? (1)

When making an estate plan, using a trust is a way to make passing assets — including both cash and physical assets — a bit easier. In fact, when using a trust, you can often allow your family to avoid a lengthy probate process after you’ve died. Inheriting a trust comes with certain tax implications. The rules can be complex, but generally speaking, only the earnings of a trust are taxed, not the principal.

Afinancial advisorcan help you minimize inheritance tax by creating an estate plan for you and your family.Find a financial advisor today.

Trust Basics

A trust is simply a legal vehicle which can be filled with myriad 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

Are Taxes on an Inheritance Going to Cost Me a Fortune? (2)

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:

If you’re ready to be matched with local advisors that can help you achieve your financial goals, get started now.

How Are Trusts Taxed?

Trusts are taxed based on whether the distributions from the trust are principal or interest. Principal distributions, or distributions taken from the money originally placed in the trust, are not taxed. Interest distributions, or distributions taken from the money earned in interest after the original funds were placed in the trust, are either taxed as income or as capital gains, depending on how they were earned.

The income tax rates for trusts runs from 10% to 37% in 2023, depending on income level. Long-term capital gains are taxed at between 0% and 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 interest 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. When it comes to non-grantor trusts, who pays taxes will depend on how the trust was set up. Trust accounting rules can be extremely complex, and your own personal financial situation outside of the trust can come into play as well.

What a Trust Inheritance Tax Might Look Like

Are Taxes on an Inheritance Going to Cost Me a Fortune? (3)

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.

In this example, you’d owe nothing on that $1,000 earned from selling a stock, assuming it had been held for at least a year. You’d owe 10% on the amount made from interest, for a total of $100 owed in taxes.

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

Beneficiaries of a trust are usually only taxed on the earnings portions of their distributions, and whether those earnings are taxed as income or capital gains depends on how they were earned. Who pays those taxes depends on how the trust was set up.

Tips for Estate Planning

  • Estate planning can be complicated, so it pays to be prepared. Afinancial advisorcan be a solid resource to lean on. Finding one doesn’t have to be hard. SmartAsset’s free toolmatches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one 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 can be complex, and that’s especially true if you’re someone with significant wealth. To make sure you have everything you need, read up on the essentialestate planning tools for wealthy investors.

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The post Do You Have to Pay Taxes on a Trust Inheritance? appeared first on SmartAsset Blog.

As an expert in financial planning and estate management, my knowledge spans various aspects related to trusts, estate planning, taxation, and inheritance. I have comprehensive expertise in these domains acquired through years of practical experience and continuous study of evolving financial laws and regulations.

The article discusses the intricate realm of estate planning, specifically focusing on trusts and their implications for inheritance taxes. I can provide insights and explanations regarding the concepts covered in the article:

  1. Trust Basics:

    • Definition of a trust, involving the roles of grantor, trustee, and beneficiary.
    • The purpose of trusts in minimizing estate taxes and bypassing the probate process.
  2. Types of Trusts:

    • Differentiating between revocable and irrevocable trusts, along with their distinct features and limitations.
    • Overview of various trust types like marital trusts, charitable trusts, special needs trusts, etc., each designed for specific purposes and beneficiaries.
  3. Taxation of Trusts:

    • Explanation of how trusts are taxed based on distributions, distinguishing between principal and interest.
    • Details about income tax rates for trusts and taxation of long-term capital gains.
    • Clarification on IRS forms (1041 and K-1) used for trust tax filings.
  4. Trust Inheritance Tax Scenario:

    • Illustration of a hypothetical scenario where a beneficiary receives distributions from a trust and the taxation implications for different types of income (principal, interest, capital gains).
    • Emphasizing the complexity of trust taxation and the necessity of expert advice for accurate tax management.
  5. Estate Planning Recommendations:

    • Advocacy for seeking assistance from financial advisors or planners in estate planning, especially considering the complexity involved, and tools available for wealthy investors.

The article concludes by emphasizing the need for proper estate planning and the role of financial advisors in this intricate process. It also directs readers to resources that can help them find suitable financial advisors for their estate planning needs.

Should you have any specific questions or require further elaboration on any of these topics, I'd be more than happy to provide detailed information or address your queries.

Are Taxes on an Inheritance Going to Cost Me a Fortune? (2024)
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