The question of whether or not a beneficiary pays trust distribution taxes on the income received from a trust comes up quite often. The answer depends on your particular situation. In the sections below, we will explain the circumstances when you, as a beneficiary, must pay tax and when it’s not required. But first, let’s start with the basic definitions.
What is a Trust?
A trust is a legal agreement between parties set up by one party, the “grantor,” to provide for another party, the “beneficiary.” It is usually created for various reasons. Often, it’s used to manage money or property for children and family members who are not yet old enough to handle it themselves. Trusts can be of two types: revocable and irrevocable. A revocable trust can be modified/revoked by the trust owner. On the other hand, an irrevocable trust can’t be altered or changed once it has been created.
In terms of taxation, both kinds are taxed differently. A revocable trust is treated as a taxable entity that pays taxes on any income it receives each year. Any assets distributed to beneficiaries will be taxed at the beneficiary’s rate, which means that if you receive funds from your parents’ revocable trust when they die, the money will be taxed at your rate rather than at your parents’ rate. On the contrary, an irrevocable trust does not incur taxes on the income generated by the assets; rather, the beneficiaries pay taxes on the trust distributions they receive from the trust’s income. When you have an asset in a trust, it’s important to understand what kind of tax treatment it might receive.
Interests and Principal Distributions
As a beneficiary, every time your trustee makes a distribution, you will receive a tax form from them. The tax form shows how much of the distribution is the principal amount and how much is the interest income. This will help you understand what amount is taxable and what is not.
Interest income is taxable to beneficiaries because it’s considered earned income. The Internal Revenue Service (IRS) considers earned income as anything that comes directly or indirectly from capital or labor, and interest is a form of capital.
On the other hand, if you receive a distribution from the principal balance, you are not obligated to pay taxes. This is because IRS considers that the principal amount was already taxed before being placed into the trust. Hence the interests it incurs are what should be taxed.
Optimizing the Trust Distribution Taxes
As noted earlier, a trust distribution tax is a federal tax that applies to distributions from qualified trusts. The tax rate varies from 33% to 40% of the distribution amount, but you can reduce it by taking advantage of certain exclusions. Trust distribution taxes can be high and are a major concern for many investors and individuals with trust assets.
To reduce your tax liability, you should understand how the trust distribution taxes work and what factors influence them. Similarly, you should know how the trustees’ fee structure affects your deductions, which could help lower the tax liability. Ideally, you want to reduce the number of distributions and the amount of money distributed from your trust. You can also work with an expert CPA to help you eliminate unnecessary distributions.
Seek Help Today
Trusts are a great way to distribute wealth to beneficiaries. But because they are complicated, it’s important to have a professional on your side who can help you understand how they work and how to minimize the tax burden. If you need help optimizing your trust distribution taxes or have any questions about trusts, call us today, and our trust experts at Gurian CPA would love to listen and help you make the right decisions.
