Tax Consequences of Terminating an Irrevocable Trust

An irrevocable trust is a legal entity that you cannot alter, amend or revoke after its creation. Irrevocable trusts are typically established to protect assets from creditors, benefit beneficiaries and minimize estate taxes. But there are circumstances that warrant the termination of an irrevocable trust, like when its purpose is fulfilled or its assets have been exhausted. The decision to terminate an irrevocable trust can have notable financial implications, particularly when it comes to taxes.

A financial advisor can help guide you through the estate planning process and assist in setting up an irrevocable trust.

What Happens When an Irrevocable Trust Is Dissolved?

Dissolving an irrevocable trust can be a complex process, usually requiring getting consent from all beneficiaries, filing the necessary paperwork and potentially getting court approval. In states like California, it’s necessary to file a petition to terminate the trust with the probate court.

Beneficiaries and trust assets can face notable repercussions when a trust is dissolved. For example, if the trust was designed to offer steady income, this income stream could get disrupted when the trust is terminated. Additionally, if the trust held assets that have substantially appreciated in value, this could carry significant tax implications when they’re distributed.

Potential Tax Consequences of Terminating an Irrevocable Trust

A pen and a calculator sit on top of a 1040 tax form.

When assets held within an irrevocable trust are liquidated and distributed to beneficiaries, those transactions may trigger a combination of income and capital gains taxes.

The tax liability associated with distributions will depend on whether the entity is a grantor trust or a non-grantor trust. With the former, the person who created the trust is considered the owner of the assets and is responsible for the taxes. A non-grantor trust, on the other hand, gets taxed as a separate entity. As a result, the trust itself and its beneficiaries are the ones who will pay the tax bill on the distributions.

Income Taxes

An irrevocable trust may hold assets that generate income, including bank accounts, bonds and dividend-paying stocks whose earnings are taxed as ordinary income. Keep in mind that the full value of distributions from a trust’s principal aren’t subject to income taxes—only the gains are.

In the event that an irrevocable non-grantor trust is terminated, the income that the assets have generated will presumably be distributed to the beneficiaries. It would then be their responsibility to pay the taxes on the money. However, if the trust that’s dissolved is a grantor trust, the income tax liability would remain with the person who created the trust.

Capital Gains Taxes

Assets that appreciate in value within an irrevocable trust are subject to capital gains taxes. When these profits are realized and distributed upon the termination of a trust, it’s the beneficiaries who will pay the tax rate that corresponds with their income level.

Estate Taxes

When assets are transferred to an irrevocable trust, they are removed from the grantor’s taxable estate. This lowers the person’s potential estate tax liability when they die.

Keep in mind that only large estates—those worth more than $13.99 million—are subject to the federal estate tax in 2025, so this tax is not something most people have to worry about. (Take note: The One Big Beautiful Bill Act (OBBBA) raises the lifetime estate exemption to $15 million in 2026.) This has made irrevocable trusts a valuable estate planning tool for the wealthy, helping them minimize their estate tax liability.

But in March 2023, the IRS announced that the step-up in basis does not apply to assets held in irrevocable grantor trusts. For those assets to receive the step-up, they must be included in the grantor’s gross estate and subject to the federal estate tax. The termination of an irrevocable grantor trust could trigger the estate tax if assets return to their taxable estate.

What to Consider Before Terminating the Trust

A couple goes over their estate plan with their financial advisor.

Before pulling the plug on an irrevocable trust, it’s important to consider the potential tax consequences and other possible financial implications. Particularly for individuals in the high-income bracket, the potential tax consequences could be a deterrent to terminating a trust. If the trust holds significantly appreciated assets, such as real estate or vintage cars, the beneficiaries could face a hefty tax bill upon dissolution.

Immediate financial impacts are also worth considering. For example, beneficiaries may experience a loss of income from the trust if it’s terminated.

Alternatives to Terminating an Irrevocable Trust

Ending an irrevocable trust is not the only way to address changing circumstances. In many cases, making adjustments can provide more flexibility without triggering the tax consequences that come with dissolution.

Here are some alternatives to consider:

Trust decanting. Decanting allows a trustee to move assets from an existing trust into a new one with updated terms. This can modernize provisions, change distribution rules or relocate the trust to a state with more favorable laws. Decanting keeps the trust structure intact while addressing beneficiary needs more effectively.
Modification by consent. In some states, a trust can be modified if all beneficiaries agree. These changes may allow for updated distribution terms, expanded trustee powers or adjustments that reflect new family circumstances. This approach avoids a full termination and preserves the trust’s original benefits.
Court-approved changes. When consent among beneficiaries is not possible, a court may approve modifications if circumstances have shifted significantly since the trust was created. Courts typically weigh whether the changes align with the grantor’s original intent. This option is more formal but can provide flexibility when needed.
Change of situs. The situs, or legal home, of a trust can sometimes be changed to another state. Moving a trust may provide access to better creditor protections, longer trust durations or lower state income taxes. This option can make a trust more efficient without dissolving it.
Replacement of the trustee. If dissatisfaction with a trustee’s management is the main issue, replacing them may resolve concerns. Appointing a new trustee—whether an individual or a professional institution—can restore confidence without altering the trust’s structure.

Bottom Line

Terminating an irrevocable trust can have significant tax consequences, triggering a combination of income, capital gains and estate taxes. Understanding these implications is critical before deciding to dissolve a trust. In many cases, adapting an irrevocable trust is more practical than dissolving it altogether. Exploring alternatives can help beneficiaries and trustees find solutions that maintain the trust’s protections while better fitting current needs.

Estate Planning Tips

A financial advisor with estate planning expertise can help you make a plan for your assets for when you’re no longer around. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Estate planning is about more than simply making a plan for your money. Advance directives are legal documents that enable individuals to retain control over their health care decision if they become incapacitated. If they’re something you want to consider, be sure to read SmartAsset’s comprehensive guide on advance directives for health care.