Are trust funds taxed? If so, how do trust taxes work? There must be some kind of advantage to passing down your assets via trusts instead of just giving them to your beneficiaries, right?
The short answer is that it depends. There are several types of trust funds out there, and taxes vary based on what is happening with the money. And since we recommend you open a trust, it may be helpful to go over the basics of how trust fund taxes work.
Trust Fund Taxes: A Few Definitions
Before we get started, let’s go over a few definitions of words related to trust taxes:
Beneficiary - The person or group of people for who the trust was created. They’ll benefit from the assets in the trust, such as the income generated and distributions.
Trustor - the person who originally sets up the trust fund for the beneficiary.
Distribution - Distribution of assets, such as a payment, from the trust to the beneficiary.
Interest - income generated by the assets inside the trust.
Principal - the amount originally received into the trust plus capital gains and less the capital losses, debts and expenses incurred over time.
These are important because we’ll mention them several times throughout the rest of the article.
Are Trust Funds Taxed? It Depends on the Income
The main factor that plays into trust taxes is where the distribution is coming from.
Over time, let’s say a trust earns interest of $5,000 per year. When the distributions on that $5,000 are paid out to the beneficiary, the beneficiary will need to pay taxes on that income.
That’s because the distribution came from the trust fund’s interest. It’s a different story when you’re talking about the principal.
If the trustee gives a distribution to the beneficiary and it’s from the trust fund’s principal, taxes are not paid. Why not? The short answer is that the government is assuming taxes had already been paid on that money when it was originally earned by the trustor.
How do you know if the distribution is from the fund’s interest or principal? The government starts by assuming the distribution is from that year’s interest generated by the trust. If more money is distributed, that portion comes from the principal.
So for example, let’s say the trust fund generated $5,000 in interest this year and the beneficiary received a distribution of $8,000. That means $5,000 of the distribution will be taxed because it came from the interest. The other $3,000 will not be taxed because it came from the trust fund’s principal.
How Does a Trust Tax Return Work?
Two main forms come into play with trust funds: the 1041 and K-1.
An IRS 1041 Form is similar to the IRS 1040 form. It’s used by the trust to track how much taxable income was distributed to the beneficiary. So if the trust earned $5,000 and sent all of it to the beneficiary, that is recorded in this form.
The K-1 is the form that breaks out how much of the distribution was from the principal vs. interest generated by the trust. It’s the form that helps the beneficiary understand how much to pay for their trust taxes.
Why are Trust Funds Taxed?
The short answer here is that trust funds are taxed because they’re generating income. They are a great way to shelter your assets but because it’s still generating income, the government wants a piece of the growth.
Conclusion
Are trust funds taxed? Yes, the beneficiary will pay trust taxes on the interest. If you have any questions about how this works - or trust funds in general - give us a call at 714-663-8000. We look forward to helping you set up trust funds to help protect your assets and take care of your loved ones!