How Are Trust Distributions Taxed?

A few years ago, I had a client (let’s call him John) with a sizable estate who unfortunately passed away earlier than he or his family had anticipated. As part of John’s estate plan, he decided to bequeath a portion of his assets to his four children that was to be distributed to them immediately.

I had four separate phone calls with each child, and the one common question that each of them asked during our conversation was, “Is this money going to be taxable to me when I receive it?” Additionally, his remaining estate was to be placed in an irrevocable trust for his widow to be used for her benefit during the rest of her lifetime but then ultimately distributed to his children after she passed.

She was curious about the rules surrounding her ability to access those assets, but similar to her children her primary concern was planning for any taxes she might owe now and in future years.

These were all great questions that every family should be asking in these situations; so, what were the answers to these questions and how can families answer them now to better prepare for the future?

Main Takeaways

In this article, we’ll use the above case study to explain:

• How trust income and distributions are taxed when you’re alive and your assets are in a revocable trust.
• How trust distributions are taxed when you inherit them and they are immediately distributed to you.
• How trust income and distributions are taxed when you inherit them and they are placed in an irrevocable trust to be distributed over time.
• Disclaimer: This case study is useful because I think it covers the most common type of planning issues that families can run into. However, trusts can be very nuanced and the taxation can vary depending on the type of trusts you use and the state you reside in. For your specific situation, I recommend consulting with an attorney and/or an accountant to ensure you dig into the specifics of your situation.

How are Income and Distributions Taxed in a Revocable Trust?

While John was living, he had the bulk of his assets in a revocable trust that was in his name. This provided him with a straightforward approach to his estate plan and tax plan because:

• He was able to access any of those assets at any time while he was still living.
• The trust laid out exactly how his assets should pass to his family if something were to happen to him.
• The trust was under his Social Security number, which meant that any income generated from his trust would flow through to his tax return.

Any distributions John made from his trust did not create a taxable event which meant that he could contribute to or distribute assets from the trust without adding to his tax bill each year. He did have to pay tax on any income generated by the trust, but he was always able to take money from the trust to pay the taxes if he needed it.

The exact tax varied each year and it was calculated based on the type of income that was generated by the trust. Reference the below chart to get a better sense of how different types of income and gains are taxed.

How are Trust Distributions Taxed Immediately After Death?

When John passed away, our firm worked closely with his attorney to determine how his assets needed to flow to his widow and children. His revocable trust indicated that a portion of the trust assets should be distributed to children immediately.

Below were the important factors that were considered to determine the taxation of those assets:

• The investments in the trust received a step-up in cost basis on the day of his death, removing any taxable appreciation on those assets that occurred during John’s lifetime.
• The assets then had to be moved into an “estate account” before they were distributed according to the terms of John’s trust.
• Between the time of death and the time of distribution, there was some slight appreciation in the values of the investments he had. The family had a choice to distribute those assets “in-kind” to his beneficiaries or sell enough of the assets to distribute cash to the beneficiaries.

If the assets were distributed “in-kind” to the beneficiaries, the children would then be responsible for any gain triggered by those assets when they eventually sold them. If they sold them in the estate account and then distributed cash to the beneficiaries, then John’s estate would be responsible for paying the tax on any gain that was generated.

Ultimately, it was decided to sell the investments before distribution so that John’s children would not have to pay any tax on the inheritance from the trust.

Pro Tip: It is important to note that these assets came directly from the revocable trust. If John had left part of his IRA or 401(k) directly to his children or to his revocable trust, then those assets would always be taxed at ordinary income rates. Knowing the source of the inheritance is critical in determining its taxability.

How is Income From an Irrevocable Trust Taxed if it is Distributed?

After the bequests were made to his children, the remainder of John’s estate flowed into an irrevocable “family trust” that was set up for the benefit of his widow during the rest of her lifetime.

Every trust is different, so we spoke with her attorney to determine these important provisions going forward:

• She was entitled to any income generated from the trust each year. “Income” is a broad category that can take on varying definitions, so we spoke with her attorney and accountant to determine what was to be categorized as income (as an example, sometimes capital gain distributions are not defined as “income”).
• She also had the ability to access any principal necessary to maintain her lifestyle. However, any principal that remained in the trust would be passed to her children and would not be included as part of her estate after her death. Essentially, leaving additional principal in the trust could save her family from paying estate taxes down the line.
• Each year, we began to calculate how much income was generated by the trust and we would coordinate with her accountant to see if this money should be distributed to the widow. Money that was distributed to her would ultimately be reported on her tax return.

However, what if she didn’t need the income to live on and left it in the trust each year?

How is income from an irrevocable trust taxed if the trust retains it?

This is where proactive tax planning becomes critical for wealthy families. Many wealthy widows assume that if they do not need income from a trust, they should just leave it in the trust, let it continue to grow, and have the trust pay the tax bill each year. However, irrevocable trusts have their own tax ID number which means that they are treated like a separate person or entity from the IRS’s perspective. More importantly, trusts have their own tax schedule that is different from individual tax schedules.

The main thing to keep in mind is that income left in an irrevocable trust can be subject to trust tax rates, which reach the highest tax bracket much more quickly than individual tax rates. In many cases, this means that widows that leave income in a trust can end up paying much more in taxes than if that income was distributed to them each year.

Pro Tip: Sometimes you can deduct trustee fees or other administrative costs like attorney or accountant fees to offset income generated by the trust. By taking a close look at this, you may not have to distribute all of the income generated by a trust and you can offset some of the tax liability owed by either the trust or an individual.

Work with an Attorney and/or CPA on Your Schedule K-1 (1041) Form

To bring this home, I think the following lessons can be garnered from this case study surrounding the taxation of trust distributions:

Lesson #1: Properly Interpreting the Trust Document is Paramount

• The importance of putting trusts in place before death is usually communicated well in the media and by attorneys, but the importance of interpreting and abiding by trust language is communicated less often. Engage with the proper professionals to ensure you stay compliant with your family’s trusts.

Lesson #2: Tax Planning with Trust Distributions is Nuanced

• You can see in the above example that both the widow and children had different choices in how trust distributions could be handled. The difference between the right choice and the wrong choice can create a sizable difference in your annual tax bill.

As the “Great Wealth Transfer” of trillions of dollars occurs over the next 20 years, our firm recognizes that issues like this are some of the most important ones investors will have to address.

That is why here at McCabe & Associates we have differentiated ourselves by structuring a firm culture that proactively coordinates and communicates with attorneys and accountants in a way that is second to none. We look forward to working to manage your family’s needs across several generations.

Types of Income Tax to Consider

Disclaimer

Cetera Wealth Services, LLC exclusively provides investment products and services through its representatives. Although Cetera does not provide tax or legal advice, or supervise tax, accounting or legal services, Cetera representatives may offer these services through their independent outside business. This information is not intended as tax or legal advice. 10% IRS penalty may apply to withdrawals prior to age 59 ½. Income may be subject to local, state and/or the alternative minimum tax.