How Are Annuities Taxed in a Trust?

Annuities can provide a steady income stream, but taxation becomes more complex when held in a trust. The tax treatment depends on the trust type, distribution method, and whether gains come from withdrawals or lump-sum payments. Understanding these rules helps ensure compliance with IRS regulations and avoid unnecessary tax burdens.

Trusts have unique tax structures that determine whether taxes are paid by the trust or its beneficiaries. The way annuity earnings are distributed and reported affects overall tax liability.

Taxable Portion of Annuity Income

When an annuity is held in a trust, the taxable portion depends on how earnings accumulate and are withdrawn. Annuities grow tax-deferred, meaning taxes are owed only upon distribution. The IRS applies the “last-in, first-out” (LIFO) rule, meaning earnings are withdrawn before the principal, making distributions taxable until all gains are exhausted.

The tax rate depends on whether the trust is a grantor or non-grantor trust. Non-grantor trusts are taxed as separate entities and follow compressed tax brackets, with income above $15,200 in 2024 taxed at 37%. Grantor trusts report annuity income on the grantor’s personal tax return, where it is taxed at individual rates.

If the annuity was purchased with after-tax dollars, only the earnings portion of each distribution is taxable, while the original investment (cost basis) is returned tax-free. The IRS uses an exclusion ratio to determine taxable and non-taxable portions for periodic payments. If a non-qualified annuity is taken as a lump sum, the entire gain is taxed as ordinary income in the year of withdrawal.

Trust Classification

The taxation of annuities within a trust depends on how the trust is structured. Different types of trusts have distinct tax treatments, determining whether the trust or its beneficiaries pay taxes on annuity income.

Simple Trust

A simple trust must distribute all income to beneficiaries annually and cannot distribute principal. Since annuity payments are considered income when received, they must be passed through to beneficiaries in the year earned. The trust does not pay taxes on this income; instead, beneficiaries report it on their personal tax returns.

For example, if a simple trust receives $10,000 in annuity income, it must distribute the full amount to beneficiaries, who then report their share as ordinary income. The trust files Form 1041 to report the income but deducts the distributed amount, shifting tax liability to beneficiaries. If the annuity payment includes both earnings and return of principal, only the taxable portion is reported as income.

Complex Trust

A complex trust has more flexibility in managing annuity income. It can retain earnings, distribute them partially, or distribute principal. If the trust retains annuity income, it is taxed at trust tax rates, which are highly compressed. In 2024, any trust income exceeding $15,200 is taxed at 37%.

For instance, if a complex trust receives $20,000 in annuity income and retains the full amount, the first $3,100 is taxed at lower rates, but the remaining $16,900 is taxed at 37%, resulting in a tax liability of approximately $6,253. If the trust distributes $10,000 to beneficiaries, only the retained portion is taxed at trust rates, while the distributed amount is taxed at individual rates.

Complex trusts must manage distributions carefully to minimize taxes. Retaining too much income leads to higher taxes, while distributing more shifts the burden to beneficiaries, who may be in lower tax brackets. The trust reports retained income on Form 1041 and issues Schedule K-1 to beneficiaries for distributed amounts.

Grantor Trust

A grantor trust is treated as an extension of the grantor for tax purposes, meaning all annuity income is reported on the grantor’s personal tax return. The trust itself does not pay taxes, and income is taxed at the grantor’s individual rates rather than the trust tax brackets.

For example, if a grantor trust receives $15,000 in annuity income, the grantor must include this amount on their personal tax return. If the grantor is in the 24% tax bracket, they would owe $3,600 in federal taxes. This structure can be beneficial if the grantor’s tax rate is lower than the trust’s compressed rates.

Grantor trusts are commonly used for estate planning, allowing the grantor to maintain control over assets while ensuring favorable tax treatment. Since the IRS disregards the trust as a separate entity for income tax purposes, a separate trust tax return is generally not required unless needed for informational purposes.

Beneficiary Allocation

How annuity income is allocated among beneficiaries affects tax liability. Trusts have discretion in structuring distributions, and the method chosen determines how much taxable income each beneficiary must report. Uneven distributions can push one beneficiary into a higher tax bracket while another owes little or no tax. Trustees must consider distribution strategies to balance tax efficiency with the trust’s purpose.

When a trust distributes annuity income, beneficiaries receive a Schedule K-1 detailing their share of taxable income. This form is necessary for filing individual tax returns. Allocation can be based on percentage shares, specific dollar amounts, or trustee discretion. Some trusts follow a pro-rata method, where each beneficiary receives an equal portion of taxable income, while others prioritize distributions based on need or other criteria outlined in the trust document.

Timing also plays a role in tax outcomes. If an annuity payment is received late in the year and distributed shortly after, the trust may still be liable for taxes in the prior year, depending on the IRS’s “65-day rule.” This rule allows a trust to distribute income within 65 days of the new year and elect to treat it as a prior-year distribution, potentially reducing the trust’s taxable income for that year.

Surrender or Lump-Sum Payouts

When a trust surrenders an annuity or takes a lump-sum payout, the tax implications can be significant, particularly if the annuity has accrued substantial untaxed gains. Unlike periodic withdrawals, which spread tax liability over multiple years, a full surrender triggers immediate recognition of all deferred earnings as taxable income in the year of withdrawal. This can push the trust into the highest federal tax bracket, where income over $15,200 in 2024 is taxed at 37%.

Surrendering an annuity within a trust also raises potential exposure to early withdrawal penalties if the contract owner—typically the trust—is under age 59½ at the time of surrender. Under IRS rules, a 10% penalty applies to the taxable portion of a distribution unless an exception applies, such as death, disability, or annuitization. Trustees should review the annuity contract carefully, as some legacy contracts may include surrender charges, which can further reduce the net proceeds received by the trust.

Reporting Obligations

Proper tax reporting is necessary when a trust holds an annuity, as errors can lead to penalties or audits. Trustees must ensure that all income, distributions, and gains are accurately documented and reported to both the IRS and beneficiaries.

If the trust retains annuity income, it must file Form 1041 and pay taxes based on trust tax brackets. Any undistributed income is taxed at the trust level, which can result in higher tax liabilities due to compressed brackets. If the trust distributes annuity income, it must issue Schedule K-1 forms to beneficiaries, detailing their share of taxable income. Beneficiaries then report this income on their personal tax returns. Trustees must also be aware of potential estimated tax payment requirements if the trust expects to owe more than $1,000 in federal taxes.

If an annuity is surrendered, the insurance company will issue Form 1099-R, reporting the total distribution and taxable portion. The trust must include this amount on its tax return, and if income is passed through to beneficiaries, they will receive a corresponding Schedule K-1. Trustees should also consider state tax implications, as some states impose additional taxes on annuity income. Proper documentation and timely filing help avoid IRS penalties, including late filing fees and underpayment interest charges.