In most cases, distributions to beneficiaries of a Trust are not taxable. The exceptions to this general rule involve estates subject to estate taxes and assets held by a decedent, or in his or her trust, that are tax qualified or tax deferred.
Estate Tax Considerations
Federal law allows an individual to pass on up to $11.58 million in 2020 to their heirs without any estate tax being imposed, up from $11.4 million in 2019. An estate includes all assets owned by a decedent, including life insurance death benefits, whether held individually or in trust.
If the total estate, including assets held personally or in trust, exceed the exemption, then the estate will be subject to estate taxes of approximately 40% of all assets that exceed the exemption. In the settlement of an estate that exceeds the maximum exemption, usually the executor of the estate or the Trustee of the trust will satisfy any estate tax obligations out of the estate before making distributions to the beneficiaries. This can often mean selling assets or property to pay the tax, and therefore does dilute the amount available to beneficiaries. Fortunately, few estates are subject to estate taxes with this relatively high exemption level.
Tax Qualified Assets
Tax qualified assets refer to qualified retirement plans (QRP), such as IRA’s, 401(k)’s, SEP IRA's, KEOUGH’s, 403(b)’s as well as deferred compensation plans. Qualified retirement plans are funds that are set aside tax free (through a deduction) and are allowed to grow tax deferred. The IRS will tax these funds at ordinary income tax rates as those funds are withdrawn, whether by the original account owner or their designated beneficiary(ies). If you are the beneficiary of a QRP, you will have to pay taxes on any amounts you withdraw. You may have options to further defer those taxes, but taxes on these types of accounts cannot be avoided unless a qualifying charity is named the beneficiary.
Tax Deferred Assets
Tax deferred assets are those assets you are able to invest with after tax dollars, but which are allowed to grow tax deferred until withdrawn. The most common tax deferred asset class are annuities. Similar to a QRP, tax deferred assets are subject to ordinary income taxes as the funds are withdrawn. However, you will only be taxed on the earnings in the policy and not the original after tax contributions.
A Note About Capital Gains
When an individual dies owning appreciated assets such as real estate or stocks, the IRS provides a tax break known as “step up basis.” This means that, for tax purposes, such assets are revalued as of the date of death which serves to eliminate any capital gains on the assets up to the value as of the date of death. The most common example is the family home that may have greatly appreciated since its purchase. After the death of the owner, all capital gains — including any depreciation taken over the years (in the case of investment property) — is forgiven. This is true whether the appreciated asset is held individually or in trust.
