As the beneficiary of an irrevocable trust, a common way to distribute an estate to heirs, you need to know what to expect when it comes to tax time. The creator or grantor of a trust puts all assets into the hands of a trustee, who manages the trust for income and to parcel out the proceeds to the heirs. When and how those assets get passed out will affect your taxes and those of the trust.
Implications for Trust and Beneficiary
The trust is taxed on any income earned from investments or other assets, but payments to beneficiaries are deducted. Distributions to you and other beneficiaries in any year are taxed on individual returns. The amounts are reported along with other income.
Distribution Types Vary
Individual beneficiaries report income from distributions the same way the trust does. If a trust gets $500 in interest and $500 in dividends from stocks or similar investments and distributes $1,000 to you, you report $500 as interest and $500 as dividends. If the trust distributes another $500 from its principal, that's reported as ordinary income.
If you have several family members as trust beneficiaries, the trustee can reduce the tax implications by splitting distributions among individuals. Distributions also can be spread over several years, rather than being made in a lump sum. Some large irrevocable trusts provide for income to be allocated over many years so that no beneficiary is taxed for a large sum in any one year.
Trust income is generally taxed at higher rates than personal income, and distributions are deductible from the trust income, so both trust and beneficiaries benefit from distributions, whether from income or principal. A mass distribution of all assets on the death of a trust grantor may be subject to estate taxes, but those have a $5 million exemption, so most estates won't produce trust or beneficiary taxes.
Bob Haring has been a news writer and editor for more than 50 years, mostly with the Associated Press and then as executive editor of the Tulsa, Okla. "World." Since retiring he has written freelance stories and a weekly computer security column. Haring holds a Bachelor of Journalism from the University of Missouri.