Is Money From a Living Trust Taxable?

A living trust serves as an estate planning tool, allowing individuals to manage assets during their lifetime and facilitate their orderly transfer to beneficiaries without the complexities of probate. This legal arrangement involves placing assets into a trust, which is then managed by a trustee for the benefit of designated beneficiaries. The tax implications of money held within or distributed from a living trust are not uniform; they depend significantly on the trust’s specific structure and how it operates. Understanding these distinctions is important as the tax treatment impacts the grantor, the trust, and its beneficiaries.

Understanding Living Trusts and Tax Identity

Living trusts primarily fall into two categories: revocable and irrevocable, each carrying distinct implications for tax identity. A revocable living trust allows the grantor to retain complete control over the assets. The grantor can amend, revoke, or terminate the trust at any point during their lifetime. For federal income tax purposes, a revocable trust is considered a “grantor trust,” meaning the IRS views the trust’s assets and income as belonging to the grantor.

Consequently, the trust does not require its own separate tax identification number (EIN) while the grantor is alive. Instead, the grantor’s Social Security Number (SSN) is used for all tax reporting related to the trust’s income. All income, deductions, and credits generated by the trust’s assets are reported directly on the grantor’s personal income tax return, Form 1040, making the trust transparent for tax purposes during this period.

Conversely, an irrevocable living trust functions as a separate legal entity from its grantor once established. The grantor relinquishes control over the assets transferred into an irrevocable trust, meaning the trust cannot be amended, revoked, or terminated without the consent of the beneficiaries. This separation of control means that an irrevocable trust requires its own Employer Identification Number (EIN) for tax purposes. The trust is responsible for its own tax filings and is considered a separate taxable entity.

Taxation of Trust Income

The taxation of income generated by assets held within a living trust varies significantly based on whether the trust is revocable or irrevocable. For a revocable living trust, any income produced by the trust’s investments, such as interest, dividends, or capital gains, is treated as the grantor’s personal income. This income is reported on the grantor’s individual Form 1040, aligning with the “grantor trust” principle.

With an irrevocable trust, the income taxation structure changes because the trust is considered a separate legal entity. If the irrevocable trust retains income, meaning it does not distribute the earnings to beneficiaries, that income is taxed at the trust level. Trust income tax rates are often more compressed than individual income tax rates, meaning trusts can reach the highest federal tax brackets at much lower income thresholds. For example, in 2024, an irrevocable trust could reach the top federal income tax rate of 37% on taxable income exceeding approximately $15,200.

If the irrevocable trust sells assets, capital gains are taxed to the trust if they are retained and not distributed to beneficiaries. Long-term capital gains for trusts also have specific tax brackets, with a 0% rate for gains up to $3,150, 15% for gains between $3,150 and $15,450, and 20% for gains over $15,450 in 2024. This incentivizes trustees to distribute income to beneficiaries, especially if beneficiaries are in lower individual tax brackets, to potentially reduce the overall tax burden. The trust may deduct these distributed amounts from its own taxable income.

Taxation of Distributions to Beneficiaries

When beneficiaries receive money or assets from a living trust, the tax implications depend on whether the distribution is considered trust principal or trust income. Distributions of trust principal, which represent the original assets placed into the trust, are not taxable to the beneficiary. This is because the principal was funded with assets on which taxes had already been paid or were otherwise exempt from income tax when contributed. For example, a specific bequest of a certain dollar amount or a specific asset is considered a principal distribution.

Conversely, distributions of trust income are taxable to the beneficiary. This income, known as Distributable Net Income (DNI), includes earnings such as interest, dividends, or rental income generated by the trust’s assets. The concept of DNI ensures that income is taxed only once, either at the trust level or by the beneficiaries, but not both. When income is distributed to beneficiaries, the trust receives a corresponding deduction for that distribution, which reduces the trust’s own taxable income.

The beneficiary then includes their share of the distributed income on their personal income tax return. The character of the income, such as ordinary income or capital gains, passes through to the beneficiary. If a distribution exceeds the trust’s current year income, the excess amount is treated as a non-taxable principal distribution.

Trust Tax Reporting

The practical aspects of tax reporting for living trusts differ based on the trust’s nature. For a revocable living trust, a separate tax return is not required during the grantor’s lifetime. All income and deductions associated with the trust’s assets are reported directly on the grantor’s individual income tax return, Form 1040, using the grantor’s Social Security Number.

For an irrevocable trust, or once a revocable trust becomes irrevocable (upon the grantor’s death), obtaining an Employer Identification Number (EIN) is a necessary step. This EIN functions like a Social Security Number for the trust, serving as its unique identifier for tax purposes. The trustee of an irrevocable trust is required to file Form 1041, the U.S. Income Tax Return for Estates and Trusts, annually. This form reports the trust’s income, deductions, gains, and losses.

If an irrevocable trust distributes income to its beneficiaries, the trustee must also issue a Schedule K-1 (Form 1041) to each beneficiary. This Schedule K-1 details the beneficiary’s share of the trust’s income, deductions, and credits. Beneficiaries then use the information provided on their Schedule K-1 to report their share of the trust’s income on their personal Form 1040. This procedural flow ensures that income distributed to beneficiaries is appropriately taxed at their individual level, while the trust receives a deduction for the distributed amounts, preventing double taxation. A Form 1041 is required if the trust has any taxable income, gross income of $600 or more, or a nonresident alien beneficiary.