Taxes on Trust Funds: How They’re Taxed & Who Pays

Summary:

Both the trust and its beneficiaries can be subject to taxes on the trust’s income. Who pays the taxes depends on the type of trust and the type of funds that are distributed.

When we think of trust funds, we think of young people who have inherited large amounts of money from their families. And while that’s sometimes the case, trust funds — technically just known as trusts — have far more uses than that. In fact, trusts are a valuable estate planning tool for families at nearly every level of income.

If you’re the creator or beneficiary of a trust, it’s important to understand how taxes on a trust fund work. In many cases, there are two different taxpayers who could pay taxes on the trust income: the trust itself and its beneficiaries. In this guide, we’ll break down how the different types of trusts are taxed and how you’ll be taxed if you’re a trust beneficiary.

How are trusts taxed?

There are several different types of trusts, each of which may be taxed differently. While some trusts are exempt from taxes because of their ownership structure, others must file tax returns and pay taxes just like any other individual would.

IMPORTANT! To learn the type of trust you have and, therefore, how it will be taxed, see the trust agreement.

Grantor trust

A grantor trust is one where the person who created the trust maintains ownership of the assets within it. For example, if you create a grantor trust with $100,000 of assets, those assets really belong to you. The trust essentially acts as a vessel to store them.

Because the trust’s assets are owned by the creator, the trust itself has no tax liability. There’s no trust tax return to be filed, nor will the trust be subject to income or capital gains taxes.

Instead, any tax liability on the assets of the trust belongs to the grantor themselves. The grantor reports any trust income on their own tax return and pays any taxes owed.

Non-grantor trust

A non-grantor trust is one where the creator of the trust doesn’t own the assets in it. Because the assets within the trust — as well as the income they create — belong to the trust, it’s the trust that’s responsible for any tax liability. The trust is a separate legal entity, and a trust’s income tax return will have to be filed.

There are two primary types of non-grantor trusts. A simple trust distributes all income earned from the trust to its beneficiaries each year but makes no distributions of the trust’s principal balance. Any non-grantor trust that doesn’t fit the requirements of a simple trust is considered a complex trust. The two are treated the same for tax purposes.

Non-grantor trusts are subject to the following income tax rates:

IncomeTaxes owed
$0 to $2,90010%
$2,900 to $10,550$290 + 24%
$10,550 to $14,450$2,126 + 35%
$14,450 or more$3,491 + 37%

Pro Tip

While non-grantor trusts must pay taxes, they may also be eligible for tax deductions on the amount of the income that’s passed along to the trust beneficiaries. This income distribution deduction will reduce the amount the trust owes for income tax purposes. To make sure you get as many deductions as possible, file your taxes using one of the tax software below.

How trust beneficiaries are taxed

The trust isn’t the only one that could pay taxes on their income. Trust beneficiaries, meaning the people who receive distributions from the trust, are also likely to have some tax liability.

Each year, a non-grantor trust must issue a tax form called the Schedule K-1 federal tax form to its beneficiaries. This form is similar to the W-2 form you might receive from your employer in that it reports the income the beneficiary received. This form also breaks down how much of the distributions were principal versus interest income and the amount of taxable income the beneficiary must claim.

Principal versus interest distributions

The amount of income taxes you’ll pay on trust distributions depends on whether those distributions consist of interest income, accumulated principal, or both.

A trust’s principal is the amount that was initially deposited. When the principal is passed along to beneficiaries in the form of distributions, those beneficiaries don’t have to pay taxes on it. The assumption is the money has already been taxed at some point, either through income taxes on the trust creator or income or capital gains taxes on the trust.

Interest income, on the other hand, is taxable income for the beneficiary who receives it. This type of income must be reported as the beneficiary’s own taxable income on their income tax return. If you receive interest income from a trust, it will be taxed at your normal income tax rate.

Pro Tip

Income distributed to trust beneficiaries is assumed to be from the trust’s income rather than its principal. It’s only once all current year income has been distributed that a trust may distribute principal.

FAQs

How do trust funds get taxed?

Trusts are taxed similarly to individual taxpayers. They’re subject to ordinary income tax rates, which are different from the individual tax brackets. Trusts may also pay lower long-term capital gains tax rates on assets owned for more than one year, as is also the case with individual taxpayers.

Do you have to file taxes for a trust fund?

Whether a trust must file a tax return depends on the type of trust it is. Simple and complex trusts — also known as non-grantor trusts — must file their own tax returns, while grantor trusts don’t have to. However, you may still have to file a tax return as the grantor or beneficiary of a trust.

Do trust funds count as income?

The money you receive from a trust fund could count as income, depending on the source of the funds. Any interest income you receive from the trust will be taxable income, but any of the principal you receive won’t be taxed.

How do trusts avoid taxes?

You can avoid taxation on a trust by creating a grantor trust. With this type of trust, it’s the grantor of the trust that pays the taxes. The trust itself has no tax liability.

Key Takeaways

  • A trust is an estate planning tool used to pass assets along to a beneficiary or beneficiaries.
  • Grantor trusts aren’t subject to taxes because the assets in the trust are still owned by the trust creator.
  • Non-grantor trusts are subject to taxes because the assets in the trust are no longer owned by the trust creator.
  • Non-grantor trust income tax rates range from 10% to 37%, like personal income tax rates but with different brackets.
  • Trust beneficiaries are taxed on interest income they receive from a trust but not on any principal they receive.
View Article Sources
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  2. Estates & Trusts — Colorado Department of Revenue | Taxation Division
  3. What Is a Successor Trustee? Duties & Powers — SuperMoney
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  5. How the Rich Use GRATs to Get Richer — SuperMoney
  6. IRS Installment Agreement: Guide on IRS Payment Plans — SuperMoney
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