Are you the beneficiary of a revocable living trust? Do you wonder whether you need to pay taxes on a trust inheritance?
First of all if you are the surviving spouse then in most cases you are now the sole successor surviving trustor and trustee. You will not have to pay any estate taxes under either California or federal law via the unlimited marital deduction.
For the rest of you if: you have met with the trustee and possibly the other beneficiaries whom the trustor/grantor named in the trust. You may have even signed some paperwork and have received either a one-time distribution check or you may be in line for the first of many disbursements you will receive from the trust over time.
At some point you will ask: “Do I have to pay taxes on this money?
The answer to this question is that it depends on the source of the funds. If the money comes from the trust’s principal, you are okay as principal distributions are not taxable to the beneficiary. However, if the source of the distributions comes from interest of the trust (interest that the trust has recently accumulated post-death), then be aware that you may have to include the income on your tax return. I recommend that you consult with the trustee and the trust estate accountant and they should give you advice on how to handle it. In some situations, the income is reported and taxed at the trust level and in other instances it could flow to the beneficiaries via a K-1 that the beneficiary would receive. The K-1 is then reported on the beneficiary's tax return. The beneficiary also may want to contact his or her own tax professional.
How trusts and estate distributions work:
1. The trustor/grantor (maker of the trust) funds the trust by transferring certain assets into the name of the trust during lifetime. The trustor/grantor sets rules for managing the assets, names a trustee to perform this task, and names beneficiaries who will receive money from the trust.
2. After the death of the initial trustor (maker of the trust), the successor trustee sells some of these assets and places the proceeds from sales into an interest-bearing account. The initial sum of money put into this account is known as its principal.
3. Following the trust provisions, the successor trustee will at some point make a one-time final distribution. A trustee has some discretion to administer the trust and will normally only make distributions after all assets are liquidated and all debts are paid. Note that a trustee can sometimes make a preliminary distribution before making the final distribution if there is some delay in closing out the estate. In some instances the trust will provide for a stream of payments over time to a beneficiary. The trustee could use the trust’s principal, the interest it has gained over time, or a combination of both to make these payments depending on the trust’s rules and size.
As far as the IRS is concerned, the trust is responsible for any capital gains or income taxes incurred when the trustee sells or cashes out one of its assets. The money does not need to be taxed a second time, so the beneficiary does not need to pay taxes on the principal’s disbursements.
However, it is a different story when the beneficiary’s disbursements come from the trust’s interest earnings. No one has paid taxes on these payments, which are considered income, before including the money in the trust. That is why the beneficiary must pay any applicable income taxes on the disbursements they receive from the trust’s interest earnings. The trust then pays taxes on whatever interest is left after the disbursements before it is added to the trust’s principal at the end of the year. Again, in some situations, the trustee may decide to pay the taxes at the trust level. Consult with the trustee and the estate accountant on which way they are going to go on estate distributions.
Note that estate taxes are separate and are usually paid from the trust estate before distributions to beneficiaries. Very few estates in California are subject to estate taxes given the current high exemption amounts ($13.99 million in 2025).
To learn more about the inheritance process works contact Law Offices of David A. Arietta. www.ariettalaw.com or (925) 472-8000.