Do You Pay Taxes on a Trust Inheritance?
Inheriting from a trust involves specific tax rules. Learn how tax liability is assigned between the trust and beneficiary for different types of distributions.
Receiving an inheritance through a trust involves a specific set of tax considerations. A trust is a legal arrangement where a grantor allows a trustee to hold assets on behalf of a beneficiary. Whether this inheritance is taxable depends on the nature of the distribution and the type of assets involved. Federal and state laws both play a part in determining the ultimate tax liability.
The Role of the Trust in Taxation
A trust operates as a distinct taxable entity, meaning the trust itself can be responsible for paying taxes. To understand this, it is necessary to distinguish between the trust’s “principal” and its “income.” The principal, also known as the corpus, consists of the original assets that were placed into the trust by the grantor.
The income is what the principal earns over time, such as interest from bonds, dividends from stocks, or rental income from real estate. Each year, the trustee must file an income tax return for the trust using IRS Form 1041, the U.S. Income Tax Return for Estates and Trusts. This form reports all income earned and any deductions.
The factor determining who pays tax on the trust’s annual income is whether that income is distributed to the beneficiaries or retained within the trust. If the trust retains the income it earns, it is responsible for paying the income tax on those earnings.
Trusts are subject to a compressed tax bracket system and can reach the highest federal tax rates at much lower income levels compared to individuals. For example, in 2025, a trust could hit the top 37% tax rate with income over just $15,650. This structure often incentivizes trustees to distribute income to beneficiaries, who are in lower personal tax brackets.
Beneficiary Tax Liability for Trust Distributions
When a beneficiary receives assets from a trust, the tax implications depend on whether they receive principal or income. A distribution of the trust’s principal is received by the beneficiary tax-free. This is because the IRS does not tax assets again as income when they are passed to a beneficiary, as they were funded with after-tax dollars or are subject to estate tax.
When the trust distributes its generated income, that income is taxable to the beneficiary. The trust receives a deduction for the distributed amount, which prevents the same income from being taxed at both the trust and beneficiary levels.
To manage this pass-through system, the IRS uses a concept called “Distributable Net Income” (DNI). Calculated on Schedule B of Form 1041, DNI represents the trust’s taxable income available for distribution. This calculation sets the maximum amount of a distribution that can be considered taxable to the beneficiaries. Any distribution amount in excess of the DNI is treated as a tax-free distribution of principal.
The trust provides each beneficiary with a Schedule K-1. This document details the character and amount of income the beneficiary has received. The beneficiary then uses the information on the Schedule K-1 to report that income on their personal Form 1040 tax return, paying tax at their individual rate.
Tax Implications for Inherited Assets
Inheriting assets from a trust has implications for future tax liability when those assets are sold, which is governed by the “stepped-up basis” rule. The cost basis of an asset is the original value used to calculate capital gains tax upon its sale. For assets inherited from a revocable trust, the beneficiary’s cost basis is “stepped up” to the fair market value of the asset on the date of the grantor’s death.
This provision can result in a tax benefit. For instance, if the trust held stock purchased for $10 per share that is worth $150 per share on the date of the grantor’s death, the beneficiary’s basis becomes $150. If the beneficiary sells the stock for $150, they would have no capital gain and owe no capital gains tax on the appreciation that occurred during the grantor’s life.
The stepped-up basis applies to assets in revocable trusts because those assets are still considered part of the grantor’s taxable estate. However, assets held in most irrevocable trusts, which are outside the grantor’s estate, do not receive a step-up in basis. In such cases, the beneficiary may inherit the grantor’s original, lower cost basis, leading to a larger taxable gain if they later sell the asset.
State-Level Inheritance and Estate Taxes
A separate layer of potential taxation exists at the state level. The federal government does not have an inheritance tax, but a small number of states do. There is a distinction between two types of state-level taxes that can apply to inherited assets: inheritance taxes and estate taxes.
A state inheritance tax is levied on the beneficiary. The tax is paid by the person who receives the assets, and the amount owed is often based on the value of the inheritance and their relationship to the decedent. Spouses are typically exempt, and closer relatives often face lower tax rates than more distant relatives.
A state estate tax is paid by the estate or trust itself before any assets are distributed. This tax is calculated based on the total net value of the decedent’s assets located in that state. Only a minority of states impose an estate tax, and most have an exemption amount, meaning the tax only applies to estates valued above a certain threshold.
The relevant laws are determined by the state where the decedent lived or where the property was located, not where the beneficiary resides. Because the rules, tax rates, and exemptions vary by state, it is necessary to check the regulations of the applicable state to determine if any additional tax is due.