Are Trust Distributions Taxable?

Dealing with trusts and their tax rules can be confusing, especially with different types of distributions and varying tax brackets for beneficiaries. A financial advisor can help you manage these details and understand how they affect your situation. Here are some key details to consider.

How Trusts Work

Trusts are intricate legal arrangements used for various financial and estate planning purposes. At their core, trusts involve three key roles: the grantor (the person who creates the trust), the trustee (who manages the trust assets) and the beneficiary (the one who benefits from the trust).

Trusts operate by transferring ownership of assets from the grantor to the trust itself. This separation of legal ownership from beneficial ownership allows for specific instructions regarding the use and distribution of these assets. The trustee holds the responsibility to manage and administer the trust according to the grantor’s wishes.

In essence, trusts offer control, privacy and tax benefits, making them valuable tools in financial and estate planning. By understanding how trusts work, individuals can make informed decisions to protect and manage their assets efficiently.

There are two primary trust types: revocable and irrevocable.

Revocable Trusts

Think of revocable trusts as living, adjustable trusts that the grantor can alter or cancel at any time. They could help you avoid the probate process, which is the legal means of validating a will. However, this strategy does not provide as many tax benefits as irrevocable trusts.

Irrevocable Trusts

Irrevocable trusts, on the other hand, are more of a locked box. Once established, they can’t be changed or ended without the beneficiary’s consent, allowing for more significant asset protection and superior tax benefits. Not considered part of the grantor’s taxable estate, irrevocable trusts can be a potent tool in reducing an estate’s tax liabilities and shielding assets from creditors.

What Qualifies as a Trust Distribution?

Trust distributions are essentially assets or income that get passed from the trust to beneficiaries. Distributions can be cash, stocks, real estate and other assets. If a trust owns a rental property, the monthly rental income the property generates would be distributed to the trust’s beneficiaries.

Do Beneficiaries Pay Taxes on Trust Distributions?

A married couple signs off on documents creating a trust for their grandchildren.

Generally, beneficiaries are not required to pay taxes on distributions from a trust’s principal. This means that receiving funds from the principal is typically not considered taxable income. However, any income generated by the trust (such as interest, dividends or rental income) may be subject to taxes. In most cases, the trust is responsible for paying these taxes before making distributions to the beneficiaries.

Where it can get a bit more intricate is when beneficiaries receive distributions of trust income. In many cases, this income is taxable to the beneficiaries at their individual tax rates. It’s important to note that some trusts, like charitable remainder trusts, can provide beneficiaries with certain tax advantages, so it’s advisable to consult a tax professional to understand your specific situation.

Tax Benefits of Trust Distributions

Effective structuring of trust distributions can offer some important tax advantages. One key benefit is income splitting among beneficiaries. By distributing income to beneficiaries in lower tax brackets, the overall tax liability of the trust can be minimized. This strategy is particularly beneficial when the trust generates substantial income.

In addition, while not directly tied to trust distributions, transferring wealth from the grantor’s taxable estate into a trust over time can also help reduce estate tax liabilities.

Furthermore, charitable remainder trusts can provide a unique advantage by allowing individuals to donate appreciated assets to a charitable trust. This strategy can result in a charitable deduction while also eliminating the capital gains tax on the donated assets. It’s a win-win situation, as it supports a charitable cause while reducing tax obligations.

Types of Taxes You May Pay Due to a Trust

You might encounter several types of taxes due to trusts and their distributions. Here’s a look at the five tax variations you should understand as a trust beneficiary or trustee.

Ordinary Income Tax

Trusts often generate income from various sources, such as rental properties, interest and dividends. This income may be subject to ordinary income tax, which is typically levied on the trust’s earnings. If the trust holds on to that income, it pays the income taxes on it; if the trust distributes that income, the beneficiaries pay the income taxes on it.

The tax rate can vary depending on the trust’s structure and the amount of income it generates. While trustees are responsible for reporting and paying this tax on behalf of the trust, beneficiaries are liable if they receive distributions from this income.

Keep in mind that trusts are subject to different income tax brackets than individuals. Trust taxes are higher than individual taxes. For tax year 2025, the income tax brackets for trusts are:

$0 – $3,150: 10%
$3,150 – $11,450: 24%
$11,450 – $15,650: 35%
$15,650+: 37%

Capital Gains Tax

When assets held within a trust are sold or transferred, any resulting capital gains may be subject to capital gains tax. The tax rate on capital gains vary based on several factors, including the type of asset and whether it’s considered a long-term or short-term capital gain. Properly managing capital gains can help minimize the tax impact.

There are three tax brackets for long-term capital gains realized by trusts:

$0 – $3,250: 0%
$3,250 – $15,900: 15%
$15,900+: 20%

Gift Tax

Trusts can also be used for gifting purposes. If you establish a trust to gift assets to beneficiaries, you may encounter gift tax considerations. The Gift Tax applies when the total value of gifts exceeds the annual exclusion amount, which is $19,000 per recipient per year in 2025.

Estate Tax

Estate tax is a tax imposed on the transfer of assets when a person dies. When assets are held within a trust, they may still be subject to estate tax, depending on the trust’s structure and the overall value of the estate. In 2025, estates worth more than $13.99 million are subject to the federal estate tax. This number will increase to $15 million in 2026 with the One Big Beautiful Bill Act (OBBBA).

Property Tax

In some cases, trusts may hold real estate properties. Property tax is levied by local governments on the assessed value of real estate. Trustees must be aware of their obligations to pay property taxes on trust-owned properties to avoid penalties and legal complications.

Can Step-Up in Basis Reduce Taxes in a Trust?

A step-up in basis can play a major role in reducing the taxes owed on inherited trust assets. When someone dies, certain assets in their estate or trust may receive a new cost basis equal to the fair market value at the date of death. This adjustment means that any appreciation in value during the original owner’s lifetime is effectively erased for tax purposes.

For example, if a parent bought stock for $50,000 that is worth $150,000 at the time of their death, the beneficiary’s cost basis would reset to $150,000. If the beneficiary later sells the stock for $155,000, they would only pay capital gains tax on $5,000 instead of $105,000. This step-up reduces the taxable gain and can significantly lower the tax burden on heirs.

Whether a trust qualifies for the step-up depends on how it was structured. Revocable living trusts generally allow assets to receive a step-up in basis because they are considered part of the grantor’s taxable estate. In contrast, many irrevocable trusts remove assets from the taxable estate and may not provide a step-up in basis, leaving beneficiaries responsible for higher capital gains taxes when assets are sold.

The IRS clarified in 2023 that assets in an irrevocable trust not included in the grantor’s taxable estate will not receive a step-up. This makes it important to evaluate how a trust is designed and whether tax-saving opportunities may be lost by moving assets outside of the estate.

Overall, the step-up in basis can lower taxes for beneficiaries by reducing capital gains. Families using trusts in their estate plans should review with legal and tax professionals whether the trust structure allows this adjustment and how it may affect future tax liabilities.

Bottom Line

A woman signs paperwork creating a trust for her children.

Grasping how trusts and trust distributions are taxed is crucial for trustees and beneficiaries alike. When properly configured, a trust can provide financial security, protect assets, and offer significant tax benefits. Understanding the types of taxes associated with trusts, such as ordinary income tax, capital gains tax, gift tax, estate tax and property tax, will help the estate distribute assets without triggering unnecessary tax liability.

Estate Planning Tips

The IRS announced in March 2023 that assets held in an irrevocable trust won’t receive the step-up in basis if they aren’t included in the grantor’s taxable estate at the time of their death. Without the step-up in basis, the value of an asset doesn’t automatically jump to the current market value, increasing the eventual tax liability.
A financial advisor with estate planning expertise can be a valuable resource in this often complicated process. 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.