How Much Can You Inherit From a Trust Without Paying Taxes?
Navigate the tax rules for trust inheritances. Discover how much you can receive from a trust while minimizing your tax liability.
A trust is a legal arrangement allowing a person, known as the grantor, to transfer assets to a trustee for the benefit of designated individuals or entities, called beneficiaries. These structures are frequently used in estate planning to manage and distribute wealth. While trusts offer flexibility and control over assets, understanding how inheritances from trusts are taxed is important for beneficiaries. The tax treatment of distributions can vary significantly depending on the nature of the assets and the type of trust involved.
Understanding Trusts and Inheritance Tax Basics
A fundamental distinction in trust distributions is between principal and income. Trust principal, or corpus, refers to the original assets placed into the trust, such as cash, real estate, or investments. Trust income, conversely, includes earnings generated by these principal assets, like interest, dividends, or rental payments. This differentiation is important because the tax treatment for beneficiaries typically depends on whether they receive principal or income. Generally, inheritances of principal are not taxed to the beneficiary at the federal level, but distributed income is.
Federal Tax Implications for Trust Distributions
The federal estate tax exemption plays a significant role in determining how much can be inherited from a trust without federal taxation. For individuals who pass away in 2025, the federal estate tax exemption is $13.99 million. Married couples can combine their exemptions, effectively shielding $27.98 million from federal estate tax. This exemption applies to the deceased person’s entire estate, not just assets held in a trust, and it is paid by the estate before distributions are made to beneficiaries. Consequently, most inheritances, including those from trusts, pass to beneficiaries free of federal estate tax because the estate’s value rarely exceeds this high threshold.
While the principal of an inheritance is generally tax-free to the beneficiary, income generated by the trust and distributed to beneficiaries is typically taxable to them. This income can include interest, dividends, or capital gains realized within the trust. The trust may deduct these distributed income amounts on its own tax return, and the beneficiary then reports them on their personal income tax return. For example, if a trust earns $10,000 in dividends and distributes it to a beneficiary, that beneficiary will include the $10,000 as dividend income on their tax return.
Another important federal tax consideration for inherited assets, including those held in trusts, is the stepped-up basis rule. This rule dictates that the cost basis of an inherited asset is adjusted to its fair market value on the date of the decedent’s death. This adjustment can substantially reduce or even eliminate capital gains tax for the beneficiary if they later sell the asset. For instance, if an asset was purchased years ago for $100,000 and is valued at $500,000 at the time of inheritance, the beneficiary’s new cost basis becomes $500,000. If the beneficiary then sells the asset for $500,000, there is no taxable capital gain.
State-Level Inheritance Taxes
Beyond federal tax rules, beneficiaries should be aware of state-level inheritance taxes, which are distinct from federal estate taxes. These taxes are levied by a handful of states directly on the individual receiving the inheritance, rather than on the deceased’s estate. The rules for these taxes vary considerably by state.
Currently, only six states impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rates and exemptions often depend on the relationship between the beneficiary and the deceased; for example, spouses and direct descendants are frequently exempt or face lower rates compared to more distant relatives or non-relatives. Even if a federal estate tax is not due, a state inheritance tax could still apply to the beneficiary, potentially reducing the net amount received.
Receiving and Reporting Trust Inheritances
When beneficiaries receive distributions of income from a trust, they will typically receive a Schedule K-1 (Form 1041) from the trust’s fiduciary. This document is for tax reporting purposes. The Schedule K-1 details the beneficiary’s share of the trust’s income, deductions, and credits for the tax year.
Beneficiaries must then use the information provided on the Schedule K-1 to accurately report their share of the trust’s income on their own personal income tax return, Form 1040. It is important to note that distributions of trust principal are generally not taxable to the beneficiary and, therefore, are not usually reported on the Schedule K-1 or the beneficiary’s individual income tax return. The K-1 ensures that income distributed from the trust is correctly attributed and taxed at the beneficiary’s individual tax rates.