Trust Funds and Inheritance Taxes: The Basics

Published July 14th, 2020 

Reading Time: 4 minutes

Written by: The Zoe Team

What is a trust fund? What types of trust funds are there? How are taxes handled when inheriting a trust fund? What qualifies as an inheritance?

Inheriting a trust fund, property, or another type of unearned income provides ample opportunities, but also carries significant responsibilities for its beneficiaries. It can be exciting to receive these sorts of unexpected additional funds, but the rules around inherited or “unearned” income are quite confusing. Taxes, in particular, are a liability that comes with receiving a trust or other inheritance. The good news is that unlike taxes on your salary, taxes on unearned income tend to be lower. To understand inheritance trusts further, let’s explore the basics of types of taxes that apply to unearned income sources like inheriting a trust fund.

What is a Trust Fund? 

A trust or trust fund is a source of income or assets, directed and monitored by a third-party (trustee) on behalf of a grantor and/or beneficiary(ies). A trust is generally created by someone, known as the grantor, looking to protect their finances from taxes and pass possessions, such as monetary assets or property, onto loved ones. 

Trust funds fall into one of two main categories

  1. Revocable (living) trusts can be assigned to any beneficiary following the grantor’s death. Changes can be made to the trust while the grantor is still alive. The ability to modify the trust, while handy, means it also loses certain benefits (ie. creditor protection.)
  2. Irrevocable trusts have terms that can’t be changed or terminated without the permission of the person who’ll be receiving the trust. The grantor legally loses the rights of ownership over the assets and transfers ownership over completely to the trust’s beneficiary.  

Taxes on Trusts

If you become heir to a trust fund, you become responsible for any associated taxes. That said, taxes on those funds are only applicable to any income that the fund has received following the trust’s inception, otherwise known as the principal. This also applies to income that is distributed to beneficiaries. If capital gains apply, these are taxed to the beneficiary of the trust. Once the fund has been received by the trustee, they are required to report fund distributions. If changes are made to the grantor’s distributable income, the tax payment is carried by the trust, rather than the beneficiary(ies). A financial advisor can help navigate the complexities of capital gains associated with receiving a trust, as well as the various tax forms that come with receiving a trust. 

Trust Tax Forms 

When the trust is granted to the beneficiary(ies), the trustee is responsible for reporting on Form K-1. Form K-1 details the principal and the interest amounts within the fund. Often, a trust fund is accredited by an employer identification number which is recorded on Form 1040 or Form 1041, and used to report any gains or losses on the initial endowment. Form 1040 is used if the money is paid out to the beneficiary(ies). Form 1041 is completed when the revenues are preserved by the trust. 

Keep in mind that the trustee will not have to pay taxes if the fund’s assets are distributed to the beneficiary(ies), prior to any income being earned. Simply put, if the trust has not earned any income, then the trustee will not have to report Form 1041. In the case of an irrevocable trust, if the account retains grosses and has the freedom to distribute amounts, tax payment of $3,011.50 is required, additional to 37% of the excess over $12,500.

What Qualifies as an Inheritance?

Inheritance” refers to an asset (or assets) that are left to a loved one following the death of the proprietor; as per their last will or testament. Inheritance may be in the form of jewelry, a property, a set amount of money in cash or investments, or other types of an estate. These are all subject to inheritance tax.

Taxes on Inheritances

Inheritance tax is the amount payable by the heir, on what has been received. Inheritance tax is often interchanged with the term estate tax. However, the two are very different. Where estate tax focuses on the transfer of entire estate ownership and the importance of property value, inheritance tax centers on the heir. In many cases, estates are often taxed twice: first at the state level and then at the federal level. Inheritance taxes, in particular, are only accumulated by states. 

Only 6 states require an inheritance tax: Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania, and Iowa. Tax percentages differ for each state and are subject to change (they currently sit between 1% to 20%). Despite such states imposing inheritance taxes, there are many circumstances where individuals are exempt. For example, if a person’s wife or husband passed away, the spouse is automatically exempt from inheritance tax, no matter the property’s location. In some states, children and grandchildren who inherit property may also avoid the inheritance tax.

The estate’s value will determine how an individual might approach the associated tax. If the estate has a hefty sum, then an estate planner will best guide an individual on how to minimize the tax burden. Where the estate is smaller, then exemptions to inheritance taxes differ for each heir. As mentioned, inheritance tax rates vary according to each state, and an heir’s relationship to the deceased determines an individual’s tax bracket for any involved assets.

For example, an heir with no familial relationship with the deceased is more likely to pay a higher tax rate. Inheritance tax can be avoided if the heir asks the proprietor to provide them with an allotment of the inheritance on a yearly basis. As of 2020, $15,000 can be freely gifted to a person without any tax sanctions. Those who are married with property can give away up to $30,000. As with a trust fund, another alternative is that the heir asks the proprietor to set up a revocable trust fund.

The Basics: Taxes on Trust Funds and Inheritances  

Inheriting a trust fund can make a big difference for your financial situation! While exciting, it’s important to consult an advisor who can guide you through the process of being a beneficiary and the taxes associated with your new unearned income. Given that tax rates tend to vary for each unearned income type, it is important that you understand income origin and are aware of tax liabilities. 

Although there are numerous exceptions, unearned income such as a trust or an inheritance is nearly always liable to taxation. While unearned income is usually classified as a non-professional money-making compensation unaffected by payroll taxes, as a beneficiary, you will be taxed on it as part of your adjusted gross income. Additionally, there are many circumstances where assets may be taxed at a lower rate. Consider your trust or inheritance an opportunity to further empower your financial future. A fiduciary financial advisor with experience in managing these funds can make the difference in optimizing your funds and the taxes associated. 

Disclosure: This blog is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

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