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Do you have to pay taxes on a trust inheritance?

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If you’re the beneficiary of a trust, you must be wondering whether you need to pay taxes on a trust inheritance or not. You have met with the trustee and the other beneficiaries whom the trustor/grantor named in the trust. You have 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 a certain point, you will probably start wondering: “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 gained over time), then be ready 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. If that does not work you should contact your own tax professional. How it works: 1.    The trustor/grantor 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.    The 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 and guidelines, the trustee then makes a one-time distribution or makes regular payments/disbursements to the grantor’s beneficiaries. The trustee can 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. 4.    The trustee could more assets to make sure there is enough money to fund the next disbursements. Any leftover interest earned by the trust is added to its principal. 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 capital gains and 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. Since interest rates have been running at an all-time low, you would have to be a beneficiary to a fairly large trust to receive an interest-funded disbursement that would materially affect your income and tax liability. Note that estate taxes are separate and are usually paid from the trust estate before distributions to beneficiaries. Very few estates are subject to estate taxes given the current high exemption amounts. To learn more about the inheritance process works contact Law Offices of David A. Arietta. or (925) 472-8000.