Beneficiaries of a trust typically pay taxes on the distributions they receive from the trust’s income, rather than the trust itself paying the tax. However, such beneficiaries are not subject to taxes on distributions from the trust’s principal.
When a trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. The K-1 indicates how much of the beneficiary’s distribution is interest income versus principal, and thus, how much the beneficiary is required to claim as taxable income when filing taxes.
Key Takeaways
- Money taken from a trust is subject to different taxation than funds from ordinary investment accounts.
- Trust beneficiaries must pay taxes on income and other distributions that they receive from the 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 disbursements.
Understanding Trusts and Beneficiaries
A trust is a fiduciary relationship whereby the trustor or grantor gives another party—the trustee—the right to hold property or assets for the benefit of a third party (usually the beneficiary).
Trusts are established to provide legal protection and safeguard assets, usually as part of estate planning. Trusts can ensure assets are properly distributed to the beneficiaries according to the wishes of the grantor. Trusts can also help to reduce estate and inheritance taxes as well as avoid probate, which is the legal court process of distributing assets upon the death of the owner.
Although there are several types of trusts, they typically fall into one of two categories. A revocable trust can be changed or closed at any time during the grantor’s lifetime.
Conversely, an irrevocable trust cannot be amended or closed after it has been opened, including those trusts that become irrevocable upon the grantor’s death. The grantor—by establishing an irrevocable trust—has essentially transferred all ownership or title of the assets in the trust.
There are various tax rules for beneficiaries of income from trusts depending on whether the trust is revocable or irrevocable—as well as the type of income the trust receives.
Interest vs. Principal Distributions
When trust beneficiaries receive distributions from the trust’s principal balance, they do not have to pay taxes on the distribution. The Internal Revenue Service (IRS) assumes this money was already taxed before it was placed into the trust. After the money is placed into the trust, the interest it accumulates is taxable as income, either to the beneficiary or the trust itself.
The trust must pay taxes on any interest income it holds and does not distribute past year-end. The interest income the trust distributes is taxable for the beneficiary who receives it.
The amount distributed to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution plus subsequent ones and is income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to him or her to the extent of the distribution deduction of the trust.
If the income or deduction is part of a change in the principal or part of the estate’s distributable income, income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays a trust tax that is $3,011.50 plus 37% of the excess over $12,500.
Tax Forms
The two most important tax forms for trusts are the 1041 and the K-1. Form 1041 is similar to Form 1040. On this form, the trust deducts from its own 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 distributed money came from principal versus interest. The K-1 is the form that lets the beneficiary know the tax liability from the trust’s distributions.
The K-1 schedule for taxing distributed amounts is generated by the trust and handed over to the IRS. The IRS, in turn, delivers the document to the beneficiary to pay the tax. The trust then completes Form 1041 to determine the income distribution deduction that is accorded on the distributed amount.
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 from the trust at least some portion of its holdings. We say “person,” but technically 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—like 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 time 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, becoming a parent
- Discretionary distributions: receive the funds in amounts and at times determined by the trustee often in accordance with 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. Such amendments include adding or removing beneficiaries. Laws vary by state, but 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. Note that a revocable trust will automatically convert into an irrevocable one when the grantor dies. As the word “irrevocable” implies, the terms and features of the trust can’t be changed—and that includes the named beneficiaries. So in most cases, a trustee cannot remove a beneficiary from an irrevocable trust.
The Bottom Line
Whether beneficiaries pay tax on monies 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, however, the beneficiary doesn’t owe tax on them—because they’re considered a return of money that presumably was already taxed before it went into the trust.
The IRS has established a sort of last in, first out (LIFO) pecking order for classifying distributions: The amount is considered to be from the current year’s income first, then from the accumulated principal.
Source: https://www.investopedia.com/ask/answers/101915/do-beneficiaries-trust-pay-taxes.asp?utm_campaign=quote-yahoo&utm_source=yahoo&utm_medium=referral&yptr=yahoo