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Horizon Elder Law & Estate Planning Blog

Wednesday, May 11, 2022

Beneficiary Income Tax Planning

There is a common assumption that people who inherit through a trust do not have to pay any taxes, but that is not always correct. Because trust beneficiaries do have to pay taxes in certain situations, you will want to think about how to minimize the tax consequences for the beneficiaries of your trust.

A California estate planning attorney can help you explore your options for beneficiary income tax planning and set up an estate plan that meets your goals and needs.

Distributions of Principal vs. Interest from a Trust

The tax treatment of distributions to beneficiaries from a trust will depend on whether the trust is distributed from the trust’s principal or its interest. The law generally assumes that the person who created the trust already paid income taxes on the assets they placed within the trust when they earned or otherwise acquired those assets.

If the trust distributes part of the principal, rather than the interest income of the trust assets, the beneficiary does not have to pay taxes on that distribution of principal. On the other hand, if the trust earns interest income and distributes the interest, not the principal, to the beneficiaries, the beneficiaries have to pay income tax on the amount of interest income they received from the trust.

The trust will have to pay taxes on interest income that the trust retains and does not pay out to the beneficiaries during the year. In other words, someone will have to pay taxes on the interest the trust assets earn during the year, either the beneficiary or the trust itself.

The Internal Revenue Service (IRS) will assume that distributions to beneficiaries come first from interest the trust assets earned during that tax year. If the trust pays out to beneficiaries more during the year than the amount of interest the trust assets earned that year, the IRS will assume that the amount of distributions in excess of the interest income came from the principal of the trust. The accumulated principal of the trust includes the original principal that funded the trust and any undistributed interest from previous tax years.

Revocable and Irrevocable Trusts

The tax consequences of distributions to the beneficiaries can be different for revocable trusts as opposed to irrevocable trusts. If the grantor (the person who set up and funded the trust) is still alive and has the legal right to change the terms of the trust or revoke the trust, the trust is revocable.

When a person sets up an irrevocable trust, they can never change the terms of the distributions, the beneficiaries, or any other details of the trust. Once the grantor creates an irrevocable trust, they no longer own those assets and they cannot change their mind. All revocable trusts become irrevocable when the grantor dies.

Because the taxation rules can vary by the type of trust and there are many different kinds of trusts, you will benefit from getting legal advice on the issue of the taxation of distributions to beneficiaries. Tax planning for trust beneficiaries can be complicated and confusing. The tax codes change frequently. You will want to talk with a California estate planning attorney about the best options in your situation. Get in touch with our office today for a free consultation.


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