As a Trust Beneficiary, Am I Required to Pay Taxes?

When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary’s distribution that’s interest income, as opposed to principal. With that information, the beneficiary know how much she’s required to claim as taxable income when filing taxes.

Investopedia’s recent article on this subject asks “Do Trust Beneficiaries Pay Taxes?” The article explains that when trust beneficiaries receive distributions from the trust’s principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was put into the trust. After money is placed into the trust, the interest it accumulates is taxable as income—either to the beneficiary or the trust. The trust is required to pay taxes on any interest income it holds and doesn’t distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who gets it.

The money given to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution with any subsequent deposits. It’s income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to her to the extent of the distribution deduction of the trust.

If the income or deduction is part of a change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays trust tax that is $3,011.50 plus 37% of the excess over $12,500.

The two critical IRS forms for trusts are the 1041 and the K-1. IRS Form 1041 is like a Form 1040. This is used to show that the trust is deducting any interest it distributes to beneficiaries from its own taxable income.

The trust will also issue a K-1. This IRS form details the distribution, or how much of the distributed money came from principal and how much is interest. The K-1 is the form that allows the beneficiary to see her tax liability from trust distributions.

The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS. The IRS will deliver this schedule to the beneficiary, so that she can pay the tax. The trust will fill out a Form 1041 to determine the income distribution deduction that’s conferred to the distributed amount. Your estate planning attorney will be able to help you work through this process.

Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”

What Are the Rules About an Inheritance Received During Marriage?

A good add-on to that sentence is something like, “provided that it is kept separate from marital assets.” To say it another way, when an inheritance or any other exempt asset (like a premarital asset) is “commingled” with marital assets, it can lose its exempt status.

Trust Advisor’s recent article asks, “Do I Have To Divide The Inheritance I Received During My Marriage?” As the article explains, this is the basic rule, but it’s not iron-clad.

A few courts say that an inheritance was exempt, even when it was left for only a short time in a joint account. This can happen after a parent’s death. The proceeds of a life insurance policy that an adult child beneficiary receives, are put into the family account to save time in a stressful situation. You may be too distraught to deal with this issue when the insurance check arrives, so you or your spouse might deposit it into a joint account. However, in one case, the wife took the check and opened an investment account with the money. That insurance money deposited in the investment account was never touched, but the wife still wanted half of it when the couple divorced a few years later. However, in that case, the judge ruled that the proceeds from the insurance policy were the husband’s separate property.

The law generally says that assets exempt from equitable distribution (like insurance proceeds) may become subject to equitable distribution, if the recipient intends them to become marital assets. The comingling of these assets with marital assets may make them subject to a division in a divorce. However, if there’s no intent for the assets to become martial property, the assets may remain the recipient spouse’s property.

Courts will look at “donative intent,” which asks if the spouse had the intent to gift the inheritance to the marriage, making it a marital asset. Courts may look at a commingled inheritance for donative intent, but also examine other factors. This can include the proximity in time between the inheritance and the divorce. Therefore, if a spouse deposited an inheritance into a joint account a year before the divorce, she could argue that there should be a disproportionate distribution in her favor or that she should get back the whole amount. Of course, the longer amount of time between the inheritance and the divorce, the more difficult this argument becomes.

Be sure to speak with your estate planning attorney about the specific laws in your state. If there is a hint of trouble in the marriage, it might be wiser to simply open a new account for the inheritance.

Reference: Trust Advisor (October 29, 2019) “Do I Have To Divide The Inheritance I Received During My Marriage?”

What is a Special Needs Trust?
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What is a Special Needs Trust?

Supplemental Security Income and Medicaid are critical sources of support for those with disabilities, both in benefits and services.

To be eligible, a disabled person must satisfy restrictive income and resource limitations.

That’s why many families ask elder law and estate planning attorneys about the two types of special needs trusts.

Moberly Monitor’s recent article, “Things to know, things to do when considering a special needs trust,” explains that with planning and opening a special needs trust, family members can hold assets for the benefit of a family member, without risking critical benefits and services.

If properly thought out, families can continue to support their loved one with a disability long after they’ve passed away.

After meeting the needs of their disabled family member, the resources are kept for further distribution within the family. Distributions from a special needs trust can be made to help with living and health care needs.

To establish a special needs trust, meet with an attorney with experience in this area of law. They work with clients to set up individualized special needs trusts frequently.

Pooled trust organizations can provide another option, especially in serving lower to more moderate-income families, where assets may be less and yet still affect eligibility for vital governmental benefits and services.

Talk to an elder law attorney to discuss what public benefits are being received, how a special needs trust works and other tax and financial considerations. With your attorney’s counsel, you can make the best decision on whether a special needs trust is needed or if another option is better, based on your family’s circumstances.

Reference: Moberly Monitor (October 27, 2019) “Things to know, things to do when considering a special needs trust”

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