Receiving an inheritance that’s been placed in a trust can lead to confusion, especially when it comes to understanding the intricacies of federal estate tax, state estate taxes, and potential taxes for beneficiaries. This comprehensive guide, crafted with insights from an estate planning attorney, will provide valuable tax tips and break down the nuances of trust taxation. Our aim is to help beneficiaries decipher whether they owe income tax or capital gains tax on distributions from the trust.
Trusts are estate planning tools used to avoid probate, minimize estate taxes by utilizing the estate tax exemption amount, and distribute assets to beneficiaries, often resulting in a larger inheritance. However, trusts have complex tax implications. The kind of trust, whether revocable or irrevocable, grantor or non-grantor, determines how assets placed into the trust are taxed.
Generally, beneficiaries do not pay taxes on inheritances from revocable living trusts since the assets are included in the grantor’s taxable estate for federal estate tax purposes. However, beneficiaries may owe income tax or capital gains tax on distributions from irrevocable trusts depending on factors like whether the money came from the principal or interest income the trust distributes.
The tax laws regarding trusts can be convoluted. This article will break down key aspects like federal estate tax, state inheritance tax, the type of trust, distributions from trust principal versus interest, grantor vs. non-grantor trusts, revocable vs. irrevocable trusts, and more. We’ll also provide tax tips to minimize taxes on trust inheritances.
What is a Trust?
A trust is a legal arrangement where assets are transferred from an individual (the grantor or settlor) to a trustee who manages and distributes the assets for the benefit of the trust’s beneficiaries.
Trusts can be revocable or irrevocable. With a revocable trust, the grantor maintains control over the assets and can make changes or dissolve the trust. An irrevocable trust, on the other hand, can’t be altered once it’s established.
Trusts are commonly used as part of an estate plan to avoid probate, provide for minor children, or cater to beneficiaries with specific needs, such as those who might benefit from a special needs trust. They also serve as tools to minimize estate taxes.
Do Beneficiaries Pay Taxes on Inheritances from a Trust?
Whether or not beneficiaries will owe taxes on a trust inheritance depends on several factors:
- The type of trust (revocable or irrevocable)
- If the trust is a grantor trust or non-grantor trust
- The type of asset being distributed (cash, investments, property, etc.)
- If the distribution is from income or principal
- The beneficiary’s relation to the grantor
In general, beneficiaries do not pay taxes on inheritances from a revocable living trust since the assets are part of the grantor’s taxable estate. However, beneficiaries may owe taxes on distributions from irrevocable trusts.
Taxes on Distributions from Revocable Trusts
With a revocable living trust, the grantor retains ownership and control over the assets. All income generated by the trust’s assets is reported on the grantor’s personal tax return.
When the grantor dies, the trust becomes irrevocable. The assets are included in the grantor’s taxable estate and subject to estate taxes.
The beneficiaries do not pay income taxes on distributions from a revocable trust after the grantor’s death. This is because the assets are stepped up to fair market value as of the date of death.
However, beneficiaries may have to pay taxes on any income generated after the date of death, depending on the type of income.
Taxes on Distributions from Irrevocable Trusts
With an irrevocable trust, the grantor gives up control over the assets. The trust becomes a separate taxpaying entity.
Whether beneficiaries owe taxes on distributions depends on several factors:
Grantor vs. Non-Grantor Trust
If an irrevocable trust is structured as a grantor trust, the grantor remains responsible for paying taxes on trust income. Beneficiaries do not pay income taxes on any distributions.
With a non-grantor irrevocable trust, the trust itself pays taxes on income generated from assets using trust tax rates. Distributions to beneficiaries are taxed depending on the type of distribution.
Income vs. Principal
Trust distributions are either from income or principal.
- Income – Includes dividends, interest, rents, royalties, etc. Distributions of income are taxed as ordinary income.
- Principal – This is the main trust asset itself. Distributions from the principal are not taxed as income. However, capital gains taxes may apply if the asset has appreciated.
Simple vs. Complex Trust
Income distributions are treated differently depending on whether the trust is a simple or complex trust:
- Simple trusts – Required to distribute all income annually. Beneficiaries pay taxes on distributions at their individual income tax rate.
- Complex trusts – Can accumulate income instead of distributing. Beneficiaries pay taxes on distributions at the trust’s tax rate.
Exceptions for Inheritance Tax
While federal law does not impose an inheritance tax, a handful of states do levy their own estate or inheritance taxes.
In these cases, beneficiaries may owe inheritance tax on assets received from a trust, depending on state law. Some states exempt inheritances by close relatives.
Tips to Minimize Taxes on a Trust Inheritance
If you are expecting an inheritance from a trust, there are some steps you can take to minimize taxes owed:
- Know the terms – Understand if the trust is revocable or irrevocable, grantor or non-grantor. This determines the tax implications.
- Track income sources – Distinguish income received from the principal. Income distributions are taxed differently.
- Review tax returns – Look at the trust’s income tax returns to understand income distributions.
- Consult a tax pro – Meet with a tax professional to review the trust and determine your tax liability.
- Plan ahead – If you know you’ll receive a large inheritance, plan accordingly. You may need to make estimated tax payments.
The Takeaway on Taxes and Trust Inheritances
While trusts can seem complicated, the key points to remember are:
- Beneficiaries typically do not owe income taxes on inheritances from revocable trusts.
- Taxes may be owed on distributions from irrevocable trusts.
- Income distributions are taxed differently than principal.
- A few states impose inheritance taxes on trust assets.
- Review the trust terms carefully and meet with a tax advisor.
With proper planning, you can minimize surprises at tax time after receiving an inheritance from a trust. Consult with an experienced estate planning attorney and tax professional for personalized guidance.
Frequently Asked Questions
Do I have to pay inheritance tax on money I receive from a trust?
No, there is no federal inheritance tax or death tax. The assets in a revocable living trust are included in the grantor’s taxable estate for federal estate tax purposes. A few states, like Iowa, impose an inheritance tax, but revocable trusts are not subject to this tax.
What are the tax implications if I inherit from a revocable living trust?
With a revocable living trust, assets are stepped up to fair market value at death, so you typically don’t owe income taxes on inheritances. However, distributions after death may be taxable depending on the source – interest income the trust distributes is taxable.
How is the tax treatment different for inheriting from an irrevocable trust versus a revocable trust?
An irrevocable trust is a separate taxable entity that must pay taxes on income generated. As a beneficiary, you may owe taxes on distributions depending on whether the money came from principal or taxable income like interest the trust distributes.
If a trust distributes money to me as the beneficiary, do I have to pay income tax on those distributions?
Yes, income distributions like interest are taxable to you as the beneficiary per IRS tax laws. You must report the trust income on your personal tax return and pay any resulting income tax liability.
What can I do to minimize any taxes owed on distributions from a trust inheritance?
Work with a tax professional to understand the trust terms, track principal versus taxable income, and plan for estimated taxes. Steps to minimize taxes depend on the type of trust and distribution amount.
