Does a Trust Gain Interest From Its Investments?

A trust is a legal arrangement where a person, the grantor, transfers assets to a trustee to manage for designated beneficiaries. A trust is not a static container; it can be an active financial vehicle designed to grow its value by generating income, including interest. A trust’s ability to earn interest depends entirely on the types of assets it holds, such as interest-bearing bank accounts or bonds.

The trustee, who can be an individual or an institution, has a legal obligation to manage the assets according to the terms outlined in the trust document. These terms dictate how the assets should be invested and how any income generated should be handled. The capacity to earn interest and other income is often intended to provide a steady stream of funds to beneficiaries or to preserve and grow wealth over time.

How Trusts Generate Income

A trust’s ability to generate income is directly tied to the assets it contains. The most straightforward way a trust earns interest is by holding cash in interest-bearing accounts. These accounts provide a predictable, though often modest, return on the cash principal held by the trust.

Trusts also frequently invest in fixed-income securities to generate interest. This category includes:

• Government bonds
• Municipal bonds
• Corporate bonds

When a trust purchases a bond, it is lending money to an entity, which in return pays periodic interest payments over the life of the bond. The level of income and risk associated with these securities varies, allowing a trustee to balance the need for steady income with the preservation of the trust’s principal.

Trusts are not limited to earning only interest. Many are structured to produce income from a diverse range of sources. A trust may hold stocks that pay dividends, which represent a share of a company’s profits distributed to its shareholders. Another source of income can be real estate, as a trust owning residential or commercial properties can collect rental payments from tenants.

The Role of the Trustee in Managing Trust Assets

The trustee is the individual or institution responsible for administering the trust’s assets and carrying out the grantor’s instructions. This role includes a fiduciary duty, which requires the trustee to act solely in the best interests of the trust’s beneficiaries. The trustee must manage the assets with loyalty and care while avoiding conflicts of interest.

A guiding principle for a trustee’s investment decisions is the Prudent Investor Rule. This legal standard requires a trustee to manage the portfolio with the skill and caution that a prudent person would use in managing their own affairs. The rule emphasizes the management of the entire investment portfolio rather than evaluating each asset in isolation and encourages diversification to manage risk.

The trustee’s investment strategy is fundamentally shaped by the trust document. This legal document provides specific instructions on how the assets should be managed and distributed. For instance, a trust designed to provide for a surviving spouse might prioritize assets that produce a high level of current income. Conversely, a trust intended for a young beneficiary might focus more on long-term growth.

The trustee must also balance the competing interests of different beneficiaries. For example, a trust may have an income beneficiary who receives the earnings during their lifetime and a remainder beneficiary who receives the principal after the income beneficiary’s death. The trustee must make investment decisions that are fair to both, generating sufficient income without taking on excessive risk that could deplete the principal.

Taxation of Trust Income

Income generated by a trust is subject to taxation by the IRS. The tax liability can fall on the trust itself or on the beneficiaries, depending on the type of trust and whether the income is distributed or retained within the trust.

All taxable income earned by an estate or a non-grantor trust is reported on IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. This form is used to calculate the trust’s total income, deductions, and its distributable net income (DNI). DNI is a calculation that determines how much of the trust’s income is taxable to the beneficiaries and how much is taxable to the trust. If the trust distributes income to beneficiaries, the trust receives a deduction for that amount, and the beneficiaries report the income on their personal tax returns.

A feature of trust taxation is its highly compressed tax brackets. Trusts reach the highest federal income tax rate at a much lower income level compared to individual taxpayers. For 2025, the top federal income tax rate of 37% applies to trust income over $15,650. For single individual taxpayers, this same rate applies to income over $626,350, which can result in a substantial tax burden on income retained by the trust.

The tax treatment also differs based on the trust’s classification. A “simple trust” is required to distribute all of its income to beneficiaries each year, so the tax liability for that income passes directly to the beneficiaries. A “complex trust” has the discretion to either distribute income or accumulate it. If a complex trust retains income, it is responsible for paying the taxes on that accumulated amount at the compressed trust tax rates.

Distributing Trust Income to Beneficiaries

The process of distributing income from a trust to its beneficiaries is governed by the terms laid out in the trust document. Distributions can be mandatory, requiring the trustee to pay out all income. They can also be discretionary, giving the trustee the power to decide when, how much, and to which beneficiaries payments will be made based on their needs.

Distributable Net Income (DNI) determines the character of the income received by the beneficiary. For example, if a trust’s income is composed of interest and dividends, the income received by the beneficiary retains that same character and is reported as such on their personal tax return.

When a beneficiary receives a distribution from a trust, the trustee provides them with a Schedule K-1 (Form 1041). This document details the amount and character of the income they have received from the trust for the tax year. The beneficiary then uses the information on the Schedule K-1 to report the income on their own Form 1040.

The trustee must carefully follow the distribution standards set in the trust agreement. If the standard is for “health, education, maintenance, and support,” the trustee must evaluate the beneficiary’s circumstances to make appropriate distributions. If the standard is purely discretionary, the trustee has broader authority but must still act in good faith and in accordance with their fiduciary duties.