Does a Trust Fund Earn Interest and How Is It Taxed?
Examine the financial mechanics of a trust, including how its assets generate returns and the important tax rules for the trust and its beneficiaries.
A trust fund is a legal arrangement where a third party, the trustee, holds assets for beneficiaries. The person who creates the trust, the grantor, sets the terms for how the trustee manages these assets. Trusts can earn income through various investments as part of the grantor’s plan to provide for the beneficiaries.
How Trusts Generate Income
A trust’s income is a function of how its assets, known as the principal, are invested. While many associate this with interest, that is only one possibility. Funds held in savings accounts, money market accounts, or certificates of deposit will generate interest income.
Beyond simple interest, trusts also hold diversified portfolios of securities. Investments in corporate or government bonds produce regular interest payments, while shares of stock can provide dividends. Dividends are portions of a company’s profits distributed to its shareholders.
Another way trusts generate returns is through asset appreciation. When a trust sells an asset like stock or real estate for more than its purchase price, it realizes a capital gain. If the trust holds real estate, it can also generate income by collecting rent from tenants.
The Role of the Trustee in Managing Investments
The trustee is bound by a fiduciary duty to act in the best financial interests of the beneficiaries. This legal obligation requires the trustee to manage assets with care and impartiality, guided by the instructions in the trust document.
Most jurisdictions have adopted the “Prudent Investor Rule” to ensure responsible asset management. This rule requires a trustee to make investment decisions with reasonable care, skill, and caution, focusing on the performance of the entire portfolio rather than individual investments. The trustee must consider the trust’s purpose, timeline, and the needs of the beneficiaries.
Under the Prudent Investor Rule, diversification is a primary principle. A trustee must spread investments across various asset classes, such as stocks, bonds, and real estate, to manage risk. The trustee must also regularly review the portfolio and make adjustments based on market conditions and the beneficiaries’ circumstances.
Taxation of Trust Income
Who pays tax on a trust’s income depends on whether it is retained by the trust or distributed to beneficiaries. If the trust retains its earnings, it is responsible for paying the income tax. The trustee must file IRS Form 1041, the U.S. Income Tax Return for Estates and Trusts, to report the income and calculate the tax due.
A feature of trust taxation is its highly compressed tax brackets. For 2025, a trust reaches the highest federal income tax rate of 37% on income over just $15,200. This low threshold creates an incentive for trustees to distribute income to beneficiaries, who are taxed at their individual rates.
When a trust distributes income, the tax liability shifts to the beneficiary. The trust takes an “income distribution deduction” on its Form 1041 for the amount paid out. The beneficiary receives a Schedule K-1 from the trust, which details the amount and type of income received. The beneficiary then reports this on their personal Form 1040 and pays the tax.
The Schedule K-1 ensures that income is taxed only once. It separates income into categories like interest, dividends, and capital gains, as these can be taxed at different rates on the beneficiary’s return. This pass-through mechanism allows income to flow from the trust to the beneficiaries.
Distributing Income to Beneficiaries
The trust document is the primary guide for the trustee, outlining the grantor’s rules for distributing funds. It distinguishes between the trust’s “income” (earnings from investments) and the “principal” (the original assets).
Distributions can be structured in different ways. Some trusts mandate distributions, requiring the trustee to pay out all or a portion of the income on a regular schedule, such as annually or quarterly.
Other trusts allow for discretionary distributions, giving the trustee authority to decide when and how much to pay. These decisions are guided by standards in the trust agreement, such as paying for a beneficiary’s education, health care, or general living expenses.