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Link to original content: https://www.investopedia.com/ask/answers/101915/do-beneficiaries-trust-pay-taxes.asp
Do Trust Beneficiaries Pay Taxes?

Do Trust Beneficiaries Pay Taxes?

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Updated October 02, 2024
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Beneficiaries of a trust typically pay taxes on the distributions they receive from a trust's income. The trust doesn't pay the tax. Beneficiaries aren't subject to taxes on distributions from the trust's principal, however. The principal is the original sum of money that was placed into the trust.

A trust deducts the income that's distributed on its tax return and issues the beneficiary a Schedule K-1 tax form when it makes a distribution. The K-1 indicates how much of the beneficiary's distribution is interest income versus principal and how much the beneficiary must claim as taxable income when filing taxes.

Key Takeaways

  • Funds received from a trust are subject to different taxation rules 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 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 in which the trustor or grantor gives another party the right to hold property or assets for the benefit of a beneficiary. This named party is the trustee. Trusts are established to provide legal protection and safeguard assets, usually as part of estate planning. They can ensure that assets are properly distributed according to the grantor's intentions. Some trusts can also help reduce estate taxes. Most trusts avoid probate.

A trust can be either revocable or irrevocable. A revocable trust can be changed or closed during the grantor's lifetime. An irrevocable trust can't be amended or closed after it has been opened. Some trusts that become irrevocable upon the grantor's death. These are testamentary trusts and are typically formed according to directions left in a decedent's last will.

Varying tax rules apply to beneficiaries depending on whether the trust is revocable or irrevocable and the type of income the beneficiary receives.

The trust must pay taxes on any interest income it holds and doesn't distribute beyond year's end. Interest income that the trust distributes is taxable to the beneficiary who receives it.

Interest vs. Principal Distributions

Trust beneficiaries don't have to pay taxes on the disbursements when they receive distributions from the trust's principal balance. The principal is the original contribution made to the trust plus any subsequent deposits. Gains earned on funds held in the trust are taxable as income to the beneficiary or to the trust, however.

The amount distributed to the beneficiary is considered to be from current-year income first then from accumulated principal. Capital gains may be taxable for either the trust or the beneficiary. Income tax is paid by the trust and not passed on to the beneficiary if the income or deduction is part of a change in the principal or part of the estate's distributable income.

Trusts pay a trust tax on taxable income according to these thresholds:

Taxable Income Tax Imposed
Less than or equal to $1,500 15% of taxable income
$1,501 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
House.gov: 26 USC 1

Tax Forms

Trusts are subject to two tax forms: K-1 and Form 1041.

Form 1041 is similar to Form 1040. The trust deducts any interest it distributes to beneficiaries from its taxable income on this form. The trust also 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 and to the beneficiary so they can accurately report the associated income. The trust then completes Form 1041 to determine the income distribution deduction according to the distributed amount.

What Is a Trust Beneficiary?

A trust beneficiary is a person for whom 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. Individuals are the most typical beneficiaries but they can also be groups of people or entities such as a charity.

How Does a Beneficiary Get Money From a Trust?

Beneficiaries receive money, officially known as distributions, from a trust in one of three ways:

  • Outright distributions: They receive the funds in a lump-sum payment or two with no restrictions.
  • Staggered distributions: They receive the funds 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: They receive the funds in amounts and at times determined by the trustee, often according to the grantor's instructions and stated wishes.

Can a Trustee Remove a Beneficiary From a Trust?

A trustee can generally only remove a beneficiary if the grantor or creator of the trust has given them a power of appointment. This is a special provision in the trust agreement that explicitly allows them to make such a change.

A grantor of a revocable trust can remove a beneficiary if they have explicitly retained authority to amend a revocable trust. The trustee can amend the trust at any time if it's revocable and the grantor also acts as its trustee. The grantor is the person who set up the trust and funded it.

Neither the grantor nor the trustee can remove a beneficiary unless the terms of the trust allow that to be done if the trust is irrevocable.

The Bottom Line

Whether beneficiaries pay tax on money received from a trust depends on how the distribution is classified. The beneficiary owes income tax on the money if the funds are deemed as having come from the trust's earnings on its assets.

Whether the money is taxed as regular income or capital gains depends on the nature of the funds, such as whether the money is cash or dividends. The beneficiary doesn't owe tax if the funds are considered part of the trust's principal because the funds are considered a return of money that was already taxed before it went into the trust.

Correction - Oct. 2, 2024: This article has been updated to state that the trustee rather than the IRS provides a copy of the K-1 to the beneficiary.

Article Sources
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  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.

  2. American Bar Association. "Revocable Trusts."

  3. Internal Revenue Service. "Instructions for Form 1041 and Schedules A, B, G, J, and K-1." Page 21.

  4. Fidelity. "Trusts and Taxes: What You Need To Know."

  5. Office of the Law Revision Counsel of the United States House of Representatives, U.S. Code. "26 USC 1: Tax Imposed."

  6. Internal Revenue Service. "Form 1041, U.S. Income Tax Return for Estates and Trusts." Page 1.

  7. 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.

  8. 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.

  9. Keystone Law Group, P.C. "How to Get Trust Fund Distributions When the Trustee Is Not Paying Beneficiaries."

  10. Hess-Verdon. "Can a Trustee Remove a Beneficiary From a Trust?"

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