Beneficiaries of a trust typically pay taxes on the distributions they receive from a trust's income rather than the trust paying the tax. However, beneficiaries aren't subject to taxes on distributions from the trust's principal, the original sum of money put into the trust.
When a trust makes a distribution, it deducts the income distributed on its tax return and issues the beneficiary a tax form called a Schedule K-1. The K-1 indicates how much of the beneficiary's distribution is interest income versus principal and how much the beneficiary can claim as taxable income when filing taxes.
Key Takeaways
- Funds received from a trust are subject to different taxation than funds from ordinary investment accounts.
- Trust beneficiaries must pay taxes on income and other distributions from a trust.
- Trust beneficiaries don't have to pay taxes on returned principal from the trust's assets.
- IRS forms K-1 and 1041 are required for filing tax returns that receive trust disbursem*nts.
Understanding Trusts and Beneficiaries
A trust is afiduciaryrelationship whereby the trustor or grantor gives another party, the trustee, the right to hold property or assetsfor the benefit of a beneficiary. Trusts are established to provide legal protection and safeguard assets, usually as part of estate planning. Trusts can ensure assets are properly distributed according to the grantor's intentions. Trusts also can help to reduce estate and inheritance taxes and avoid probate.
Trusts include therevocable trust that can be changed or closed during the grantor's lifetime. An irrevocable trust can't be amended or closed after it has been opened, including those trusts that become irrevocable upon the grantor's death. Varying tax rules apply to beneficiaries, depending on whether the trust is revocable or irrevocable and the type of income the trust receives.
The trust must pay taxes on any interest income it holds and doesn't distribute past year-end. The interest income the trust distributes is taxable for the beneficiary who receives it.
Interest vs.Principal Distributions
When trust beneficiaries receive distributions from the trust's principal balance, they don't have to pay taxes on this disbursem*nt. The Internal Revenue Service (IRS) assumes this money was taxed before being placed into the trust. Gains on the trust are taxable as income to the beneficiary or the trust.
The amount distributed to the beneficiary is considered from current-year income first, then accumulatedprincipal. The principal is the original contribution plus subsequent deposits.Capital gainsmay be taxable to either the trust or the beneficiary.
If the income or deduction is part of a change in the principal or part of theestate's distributable income, income tax is paid by the trust and not passed on to the beneficiary. As of Dec. 2023, anirrevocable trustwith distributions and earnings pays a trust tax on the taxable income per the following:
| Taxable Income | Tax Imposed |
| Less than or equal to $1,500 | 15% of taxable income |
| $1,500 to $3,500 | $225 plus 28% of the excess over $1,500 |
| $3,501 to $5,500 | $785 plus 31% of the excess over $3,500 |
| $5,501 to $7,500 | $1,405 plus 36% of the excess over $5,500 |
| Over $7,500 | $2,125 plus 39.6% of the excess over $7,500 |
Tax Forms
The two tax forms for trusts are Form 1041 and K-1. Form 1041 is similar to Form 1040. On this form, the trust deducts from its taxable income any interest it distributes to beneficiaries. At the same time, the trust issues a K-1, which breaks down the distribution, or how much of the money came from principal versus interest. The K-1 is the form that lets the beneficiary know their tax liability.
The K-1 schedule for taxing distributed amounts is generated by the trust and provided to the IRS. The IRS delivers the document to the beneficiary to pay the tax. The trust then completes Form 1041 to determine the income distribution deduction according to the distributed amount.
Trust Legislation
President Biden's Build Back Better Act, proposed in 2021, would have made sweeping changes to tax implications for trusts and beneficiaries. The estate tax exemption would have been significantly reduced, for example. In addition, the law would have treated the transfer of property between a grantor and trust as a taxable event. However, the final legislative product, the Inflation Reduction Act of 2022, eliminated all provisions related to trust taxation of this kind.
What Is a Trust Beneficiary?
A trust beneficiary is a person for whom—or for whose benefit—the trust is created; they stand to inherit at least some portion of its holdings. A beneficiary can be any recipient of a trust's largesse. Though individuals are the most typical, beneficiaries can also be groups of people or even entities—such as a charity.
How Does a Beneficiary Get Money From a Trust?
Beneficiaries get money—officially known as distributions–from a trust in one of three basic ways:
- Outright distributions: Receive the funds in a lump payment or two, with no restrictions.
- Staggered distributions: Receive the funds over a certain period or at periodic intervals, often in a set sum each time; or after a specific event, such as graduation from college, reaching the age of majority, or becoming a parent.
- Discretionary distributions: Receive the funds in amounts and at times determined by the trustee often by the grantor's instructions and stated wishes.
Can a Trustee Remove a Beneficiary From a Trust?
It depends. A grantor of a revocable trust can remove a beneficiary if they have explicitly retained authority to amend a revocable trust. Thus, if the trust is a revocable living trust, and the trustee is also the grantor (the person who set the trust up), then the trustee can amend the trust at any time. Generally, the only way a trustee could remove a beneficiary is if the grantor (or creator) of the trust gave them a power of appointment—a special provision in the trust agreement that explicitly allows them to make such a change. If the trust is irrevocable, neither the grantor nor the trustee can remove a beneficiary unless the terms of the trust allow that to be done.
The Bottom Line
Whether beneficiaries pay tax on money received from a trust depends on how the distribution is classified. If the funds are deemed as coming from the trust's income—that is, earnings on its assets—the beneficiary does owe income tax on them. Whether it's taxed as regular income or capital gains depends on the nature of the funds (cash, dividends, etc.). If the funds are considered part of the trust's principal, the beneficiary doesn't owe tax because the funds are considered a return of money already taxed before it went into the trust.
Article Sources
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Internal Revenue Service. "Form 1041, U.S. Income Tax Return for Estates and Trusts," Page 1.
Internal Revenue Service. "Instructions for Form 1041 and Schedules A, B, G, J, and K-1, U.S. Income Tax Return for Estates and Trusts," Page 3.
American Bar Association. "Revocable Trusts."
Internal Revenue Service. "Instructions for Form 1041 and Schedules A, B, G, J, and K-1," Page 21.
Fidelity. "Trust and Taxes: What You Need To Know."
Office of the Law Revision Counsel of the United States House of Representatives, U.S. Code. "26 USC 1: Tax Imposed."
Internal Revenue Service. "Instructions for Form 1041 and Schedules A, B, G, J, and K-1, U.S. Income Tax Return for Estates and Trusts," Pages 3, 41.
Internal Revenue Service. "Instructions for Form 1041 and Schedules A, B, G, J, and K-1, U.S. Income Tax Return for Estates and Trusts," Page 41.
Congressional Research Service. "Tax Changes for Estates and Trusts in the Build Back Better Act (BBBA)," Page 1.
Nelson Mullins. "The Inflation Reduction Act and Estate Planning."
Keystone Law Group, P.C. "How to Get Trust Fund Distributions When the Trustee Is Not Paying Beneficiaries."
Hess-Verdon. "Can a Trustee Remove a Beneficiary From a Trust?"
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Now, let's delve into the intricacies of the article on trust beneficiaries and taxation:
1. Trust and Beneficiary Relationship:
- A trust is a fiduciary relationship where the trustor grants the trustee the authority to hold assets for the benefit of a beneficiary.
- Trusts are established for legal protection, asset safeguarding, and efficient estate planning.
2. Taxation of Trust Distributions:
- Beneficiaries of a trust pay taxes on the distributions they receive from the trust's income, not from the trust itself.
- Distributions from the trust's principal are not subject to taxes for beneficiaries.
- Trusts issue a Schedule K-1 to beneficiaries, indicating the breakdown of interest income versus principal for tax purposes.
3. Tax Forms and Process:
- IRS forms K-1 and 1041 are required for filing tax returns that involve trust disbursem*nts.
- Form 1041 is similar to Form 1040 but is specific to trusts. It allows the trust to deduct interest distributed to beneficiaries.
- Schedule K-1 is provided to the IRS, and the trust issues it to beneficiaries, detailing the distribution's nature (principal vs. interest).
4. Interest vs. Principal Distributions:
- Beneficiaries do not pay taxes on distributions from the trust's principal balance.
- Gains on the trust may be taxable as income to either the trust or the beneficiary.
- The distribution order considers current-year income first, followed by accumulated principal.
5. Trust Legislation:
- The article touches upon the legislative landscape, mentioning President Biden's proposed Build Back Better Act and its potential impact on trust taxation.
- The final legislation, the Inflation Reduction Act of 2022, eliminated certain provisions related to trust taxation.
6. Trustee-Beneficiary Dynamics:
- The article explores scenarios where a trustee may or may not remove a beneficiary, depending on the type of trust (revocable or irrevocable) and the terms of the trust agreement.
In conclusion, understanding the tax implications for trust beneficiaries involves navigating intricate tax codes, distinguishing between principal and income distributions, and staying informed about legislative changes that could affect estate planning strategies. If you have any specific questions or need further clarification on trust-related matters, feel free to ask.
