Do Beneficiaries Owe Taxes on Money from Trusts?

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Trusts do not nullify all taxes.

Your parents or grandparents created a trust or trusts as part of their estate planning.

Maybe they wanted greater control in asset distribution.

Perhaps they simply desired to shield their wealth from estate taxes.

Whatever the reason, as part of their planning they used trusts to provide the trust beneficiaries with an inheritance.

You are one of these beneficiaries.

According to a recent Investopedia article titled “Do Trust Beneficiaries Pay Taxes?,” trusts may protect an estate from a hefty estate tax, but both the estate and beneficiaries may need to pay smaller-scale taxes.

Trusts do not protect from all taxes.
Beneficiaries may need to pay taxes on disbursements from trust.

The money in a irrevocable trust is divided into two categories.

The first is the principal funds.

These were placed into the account already having been taxed.

The second portion of the trust money is the accumulated interest.

This interest will be taxable by the IRS.

Who pays these taxes?

This depends.

If the trust holds and does not distribute the interest income past the end of the year, then the trust will owe the tax.

If the trust distributes the interest income to the beneficiaries, then the beneficiaries will pay taxes.

If the distribution includes funds from the principal portion of the trust as well, then the trust will pay the income tax.

Trusts require two tax forms.

The first is IRS Form 1041.

This is similar in function to IRS Form 1040.

What does it do?

It covers the trust deducting distributed interest to beneficiaries from its own taxable income.

The second form is the K-1.

The K-1 is issued by the trust to identify the amount of the distribution from interest and principal.

The trustee generates this form and provides it to the IRS.

The trustee also will deliver it to the beneficiary, so the beneficiary will know how much to include in her personal income taxes for the year.

Trusts involve more complex estate planning and require understanding a different dimension of tax law.

Working with an qualified financial planner, CPA, and experienced estate planning attorney will help you understand how the tax law applies to you and stay in compliance with the good folks at the IRS.

Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”