If I Inherit Money From a Trust, Is It Taxable?

Receiving an inheritance from a trust brings a common question to the forefront: is this money taxable? The answer depends on what you receive and how the trust is structured. A trust is a legal arrangement where a trustee holds assets for a beneficiary. The tax treatment hinges on whether the distribution is from the trust’s original assets or the income it has generated.

Understanding Trust Principal and Income

A beneficiary can receive two types of distributions from a trust: principal and income. The principal, also known as the corpus, consists of the original assets placed into the trust, such as cash, stocks, or real estate. Distributions of this principal are considered a transfer of an inherited asset rather than income and are typically received by the beneficiary free from income tax.

The second type of distribution is trust income, which represents the earnings generated by the principal assets. Common sources include interest, dividends, rental income, and capital gains from selling a trust asset. Unlike principal, distributions of the trust’s income are taxable to the beneficiary who receives them.

The taxation of trust income is governed by a concept called Distributable Net Income (DNI). DNI is the trust’s taxable income for the year and establishes the maximum amount of a distribution that can be taxed to the beneficiaries. This framework passes the tax liability for the trust’s annual earnings from the trust to the beneficiaries who receive the money. If a trust earns income but does not distribute it, the trust itself is responsible for paying the income tax.

For example, consider a trust that earns $10,000 in dividends and interest in a given year, which is its DNI. If the trustee distributes $30,000 to a beneficiary that year, the first $10,000 of the distribution is considered taxable income to the beneficiary. The remaining $20,000 is treated as a tax-free distribution of the trust’s principal.

How the Type of Trust Impacts Taxes

Trusts are categorized as either revocable or irrevocable, and this distinction has important tax consequences for the beneficiary. The rules governing a trust while the creator is alive differ from the rules that apply after their death, which is when a beneficiary typically receives their inheritance.

A revocable trust, often called a living trust, is a flexible arrangement the grantor can change or cancel during their life. For tax purposes, a revocable trust is a “grantor trust,” meaning it is not a separate entity from its creator. The grantor maintains control over the assets and is personally responsible for reporting and paying taxes on all income the trust generates on their personal tax return.

When the grantor of a revocable trust dies, the trust automatically becomes irrevocable. At this point, the assets within the trust receive a “step-up in basis.” This means the cost basis of the assets is adjusted to their fair market value on the date of the grantor’s death. This step-up can significantly reduce or eliminate capital gains taxes if the beneficiary sells the inherited assets.

Irrevocable trusts are established as separate legal and tax-paying entities from the moment they are created. The grantor permanently gives up control of the assets transferred into the trust. Because it is a distinct entity, the irrevocable trust must file its own tax return and pay taxes on any income it earns and does not distribute. When the trust does make distributions, the tax liability for the income portion is passed to the beneficiaries.

Reporting Trust Distributions on Your Tax Return

When you receive a distribution from a trust, you must correctly report it on your personal income tax return. The trustee is responsible for tracking the trust’s financial activities and filing the necessary tax forms. The trustee is required to file an annual income tax return for the trust using IRS Form 1041, the “U.S. Income Tax Return for Estates and Trusts.” This form details all the income earned by the trust, such as interest and dividends, as well as any deductible expenses.

As a beneficiary, the most important document you will receive is the Schedule K-1 (Form 1041). The trustee must send this form to you and file a copy with the IRS. The Schedule K-1 breaks down the specific amounts and types of income you have received from the trust during the tax year.

The form contains various boxes that correspond to different categories of income you must report:

• Box 1 will show your share of taxable interest.
• Box 2a reports ordinary dividends.
• Box 3 shows net short-term capital gains.
• Box 4a shows net long-term capital gains.

The final step is to transfer the information from your Schedule K-1 to your personal tax return, Form 1040. Each box on the K-1 corresponds to a specific line or schedule on your return. For example, interest from Box 1 and dividends from Box 2a are reported on Schedule B of your Form 1040, while the capital gains from Boxes 3 and 4a are reported on Schedule D.

State Inheritance and Estate Tax Considerations

Beyond federal income tax, beneficiaries may also need to consider state-level taxes. These taxes are separate from the income tax system governed by the IRS and are imposed by the state where the deceased person resided or where the beneficiary lives. The two primary types of state-level taxes related to inheritances are estate taxes and inheritance taxes.

A state estate tax is levied on the total value of a decedent’s estate before any assets are distributed to beneficiaries. The responsibility for paying this tax falls on the estate itself, which is managed by the trustee. The tax is calculated based on the net value of the estate after deductions, and only if the value exceeds a specific exemption threshold set by the state.

A state inheritance tax functions differently, as it is paid directly by the beneficiary after they receive their distribution from the trust. Only a small number of states currently impose an inheritance tax. The states that impose this tax are Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

The amount of inheritance tax a beneficiary owes often depends on their relationship to the person who passed away. State laws set different tax rates and exemption amounts based on this relationship. For example, surviving spouses are almost always exempt from inheritance tax, while distributions to children are often taxed at lower rates than distributions to more distant relatives or unrelated individuals.