Are Beneficiaries of Trusts Required to Pay Taxes?

After working hard your whole life, like most people, you want to be able to provide financial security for yourself as well as your family and loved ones. This is why financial planning is important. Having a thorough estate planning strategy is essential. Fortunately, there are various methods and strategies available for planning the administration of your estate. 

One of the most common ways people ensure that their assets will go to their intended beneficiaries is through the use of a trust. 

What exactly is a trust? 

A trust forms a fiduciary relationship between you, the trustor, and another party, the trustee. By putting assets into a trust, you are entrusting the trustee to manage these assets and funds for the benefit of your chosen beneficiaries or heirs. The trustee will make sure that assets are distributed as you desire which can ultimately save significant expenses related to a contentious and lengthy probate process. 

Tax advantages 

Trusts are also popular due to the tax advantages this financial vehicle can provide to your heirs. Usually, you will be able to use a trust to minimize estate and inheritance tax liabilities. Your financial advisor can help you integrate a trust strategy to ensure you maximize tax advantages for your intended beneficiaries. 

Do your beneficiaries have to worry about taxes? 

Although a trust strategy can help to avoid inheritance taxes that does not mean your beneficiaries are completely in the clear when it comes to being charged taxes related to receiving benefits from the trust you have set up for them. Depending on how funds are distributed your beneficiaries may be charged income tax on these distributions. 

Interest distributions 

The determining factor for whether or not your beneficiaries will be forced to pay income tax on distributions from the trust is whether the distributions are interest payments or distributions of the principal amount. Once you have deposited funds into the trust, the trustee will manage the funds and assets. These assets may earn interest payments and income via investments. This is considered taxable income. 

Either your beneficiaries or the trust itself will be responsible for paying the income tax liabilities on interest earned. If the interest is distributed to your beneficiaries, they will be the ones who must pay the tax bill. However, if the interest is not distributed and remains in the trust, then it is the trust who will pay the income tax. 

Principal distributions 

On the other hand, distributions to your heirs taken from the principal amount you originally deposited, will not incur income tax liabilities for your beneficiaries. For tax purposes, the Internal Revenue Service (IRS) assumes that distributions to beneficiaries come from income earned during the current year. Any amount distributed after that is considered distributions from the principal. However, principal amounts may be subject to capital gains tax which can be charged to either your beneficiaries or the trust. 

Making the right estate planning decisions 

In light of potential tax consequences for your beneficiaries you will need to carefully consider how you want to design the terms of the trust. You will have to take tax planning into consideration when making other estate planning decisions as well. Seeking professional financial advice may be the best option. 

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.