Most trust inheritances are not taxable to you as the beneficiary

The money or property you receive from a trust is generally not subject to federal income tax. The trust itself may have already paid tax on the income it earned before distributing it to you, or the trust may have been set up in a way that avoids that tax altogether. Either way, you do not report the inheritance itself as income on your personal tax return.

The key distinction is between the principal (the original money or property in the trust) and the income the trust earned. Principal distributions are almost never taxable to you. Income distributions — money the trust earned through interest, dividends, or rent — may be taxable, but only if the trust did not already pay tax on them.

State inheritance taxes are a separate matter and depend entirely on where you live and where the person who created the trust lived. Most states have no inheritance tax at all. A handful do, and the rules vary widely by state.

Key Takeaways

  • Principal distributions from a trust — the original money or property — are not taxable income to you.
  • Income the trust earned and then distributed to you may be taxable, but only if the trust did not already pay tax on it.
  • The trustee or trust tax preparer will send you a document called a Schedule K-1 or 1041-B that shows what portion of your distribution is taxable.
  • State inheritance taxes exist in only a few states and depend on your state of residence and the state where the trust was created.
  • You do not report trust distributions on your personal income tax return unless the K-1 or 1041-B shows taxable income.

The difference between principal and income distributions

A trust holds assets. Those assets may earn money — interest from a bank account, dividends from stocks, rent from property. The original assets are the principal. The money they earn is income.

When a trust distributes principal to you, that is not income and is not taxable. You are straightforward receiving what was already in the trust. If the trust was funded with $500,000 and distributes $100,000 of that to you, you owe no federal income tax on that $100,000.

When a trust distributes income it earned, the tax treatment depends on whether the trust already paid tax on that income. If the trust earned $10,000 in interest and kept it, the trust paid tax on it. If the trust then distributes that $10,000 to you, you do not pay tax again — the trust already did. If the trust earned $10,000 and distributed it to you without paying tax, you owe tax on it.

The trustee decides each year whether to distribute income to beneficiaries or keep it in the trust. That decision affects who pays the tax.

How to know if your distribution is taxable

The trustee or the trust's tax preparer will send you a document after the end of the tax year. This document is either a Schedule K-1 (if the trust filed a Form 1041) or a 1041-B (a simpler version for small trusts). This form tells you exactly how much of your distribution is taxable income and how much is non-taxable principal.

You should receive this form by early March. If you do not receive it by mid-March, contact the trustee or ask for the trust's tax identification number so you can request it directly from the tax preparer.

The K-1 will show different types of income separately — ordinary income, capital gains, tax-exempt interest, and so on. You report only the amounts shown on your copy of the K-1 on your personal tax return. You do not report the principal portion.

If the K-1 shows zero taxable income, you do not owe federal income tax on the distribution, and you do not need to report it on your return.

State inheritance taxes and where they explore

Twelve states currently have an inheritance tax or an estate tax that may affect what you receive. These states are Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania, Delaware, Connecticut, Illinois, Maine, Massachusetts, and Minnesota. Oregon and Washington also have estate taxes. The rules and rates vary significantly by state.

An inheritance tax is paid by the person who receives the money — you. An estate tax is paid by the estate or trust before distribution. Some states have both, some have one, and most have neither.

Whether you owe state tax depends on two things: your state of residence and the state where the trust was created or where the person who created it lived. If you live in a state with no inheritance tax, you typically owe nothing to your state, even if the trust was created elsewhere. If you live in a state with an inheritance tax, you may owe tax on what you receive, depending on your relationship to the person who created the trust.

Most states tax spouses and children at a lower rate or exempt them entirely. More distant relatives and unrelated beneficiaries face higher rates or no exemption. Check your state's revenue or tax department website for the current rates and exemptions.

What happens if the trust earned capital gains

If the trust sold stocks, real estate, or other assets at a profit, it realized a capital gain. The trust may have paid tax on that gain, or it may have distributed the gain to beneficiaries, who then owe tax on it.

The K-1 will show capital gains separately from ordinary income. Long-term capital gains (assets held more than one year) are taxed at a lower rate than ordinary income. Short-term capital gains are taxed as ordinary income.

If the trust distributed appreciated property to you — for example, shares of stock that have gone up in value — you do not owe tax at the time of distribution. You owe tax only if and when you later sell that property. The trustee should provide you with the cost basis (what the trust paid for it) so you can calculate your gain or loss when you sell.

Distributions from a revocable living trust versus an irrevocable trust

A revocable living trust is one the person who created it can change or cancel during their lifetime. After they die, it becomes irrevocable. Distributions from a revocable trust after the creator's death are treated the same way as distributions from any other trust — principal is not taxable, and income is taxable only if the trust did not already pay tax on it.

An irrevocable trust cannot be changed by the person who created it. These trusts are sometimes used for tax planning. An irrevocable trust may have different tax rules depending on how it was set up. Some irrevocable trusts are designed to avoid estate tax, which can affect how distributions are taxed to beneficiaries. The K-1 will still show you what is taxable.

If you are a beneficiary of an irrevocable trust and the tax treatment of your distribution is unclear, ask the trustee for a copy of the trust document or contact the trust's tax preparer directly.

What to do if you do not receive a K-1

If you received a distribution from a trust and did not receive a K-1 or 1041-B by mid-March, contact the trustee in writing and ask for it. Include the trust name, your name, and the year in question.

If the trustee does not respond, you can contact the trust's tax preparer if you know who it is. If you do not know, ask the trustee for the trust's tax identification number and the name of the preparer.

Do not file your tax return without the K-1 if you received a taxable distribution. The IRS will match your return against the K-1 the trust files, and a mismatch will trigger a notice. If you cannot obtain the K-1, file your return on time anyway and attach a statement explaining that you requested the K-1 but did not receive it.

Frequently Asked Questions

Do I have to report a trust distribution on my tax return?

Only if the K-1 shows taxable income. If the distribution was entirely principal or if the trust already paid tax on the income, you do not report it. The K-1 will tell you what amount, if any, to report.

What if the trust distributed property instead of cash?

Receiving property from a trust is not taxable at the time of distribution. You receive it at its fair market value on the date of distribution, and that becomes your cost basis. You owe tax only if you later sell the property and it has increased in value since then.

Can I owe federal income tax and state inheritance tax on the same distribution?

Yes, it is possible. Federal income tax applies to taxable income the trust distributed. State inheritance tax applies to the total value of what you received, depending on your state and your relationship to the person who created the trust. The two taxes are separate.

Does a trust distribution count as income for purposes of Social Security or Medicare?

Principal distributions do not count as income. Taxable income distributions from the trust do count as income for those programs. If you receive Social Security or Medicare benefits, consult with a tax professional or call Social Security directly to understand how a large distribution might affect your benefits.

What if the trust was created in another country?

A foreign trust has different tax rules. You will still receive a K-1 or similar document, but the rules for reporting are more complex. Consult a tax professional or contact the IRS directly if you are a beneficiary of a foreign trust.