Let’s pretend you’re the beneficiary of a trust, you must be wondering whether you need to pay taxes on a trust inheritance or not.
You’ve met with the trustee and the other beneficiaries whom the grantor named in the trust. You’ve filled out some paperwork and received a check for the first of many disbursements you’ll receive from this trust over time.
At a certain point, you’ll probably start wondering: “Do I have to pay taxes on this money? Do I have to pay taxes on the inheritance from a trust?”
Unfortunately, the answer to this question is: “Well, that depends…”
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It depends mainly on the source of your disbursement. If the money comes from the trust’s principal, don’t worry because you’re free and clear. But if it comes from interest, the trust has gained over time, then get ready to call the Internal Revenue Service and include this income on your tax return.
Here’s how it works:
- The person setting up a trust, the grantor, funds the trust by transferring their assets into its name. The grantor sets rules for managing these assets, names a trustee to perform this task, and names beneficiaries who will receive money from the trust.
- The trustee sells some of these assets and places the proceeds from this sale into an interest-bearing account. The initial sum of money put into this account is known as its principal.
- Following the trust’s rules, the trustee then makes regular payments or disbursements to the grantor’s beneficiaries. He or she 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.
- The trustee sells more assets to make sure there’s 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, gift, or income taxes incurred when the trustee sells or cashes out one of its assets. The money doesn’t need to be taxed a second time, so the beneficiary doesn’t need to pay taxes on the principal’s disbursements.
However, it’s 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’s 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’s added to the trust’s principal at the end of the year.
It’s important to note, though, that interest rates have been running at an all-time low since the Federal Reserve slashed its federal funds rate to stimulate the economy during the Great Recession in 2008.
The interest rates offered by banks for savings or money market accounts followed suit, and you’d be lucky to find one that pays an interest rate even close to 1 percent per year. So, you’d have to be part of a fairly large trust – one with at least $1 million in assets – to receive an interest-funded disbursement that would affect your income and tax liability.
However, while you may not have to pay capital gains or income taxes on the inheritance from a trust, there are still other taxes and fees you may have to pay – especially if you inherit an asset itself rather than a share of the money earned from its sale.
The best way to understand these risks is to know how the estate planning process works. And the best way to do that is to sign up for a free estate planning workshop offered by PlanningCommunities.org. Click here to get started.