Trust fund income is unearned income and it's ordinarily taxable, no matter how old the beneficiary is or if he's someone's dependent. If a trust retains its income and does not distribute it to beneficiaries, it must file its own return and pay taxes on the money. If it distributes income to beneficiaries, however, it can claim a deduction for that money and the beneficiaries must report the income on their personal returns. Distributions from the trust's principal aren't subject to tax.
The first $950 in trust income received by your minor dependent isn't taxable. Assuming he doesn't earn more than this during the year, and assuming he doesn't have any earned income, he doesn't have to file a return and report it. As his parent, neither do you. Beyond this threshold, however, someone must claim the income. He can do it, or his parents can do it on his behalf.
Kiddie Tax Rates
If your dependent's trust income exceeds $950 as of 2012, and if he claims it on his own return, the kiddie tax comes into play to determine his tax rate. The IRS taxes the next $950 at the minor's rate, which is typically the lowest bracket. If his income exceeds $1,900 for the year – the $950 exclusion plus the $950 at his tax rate – his parents' tax bracket applies. For example, if the child receives $1,000 a month or $12,000 a year in trust income, he would have to pay taxes on $10,100 of that at his parents' rate, even if it's considerably more than his own.
The kiddie tax rules depend on the age of a minor beneficiary. They apply until your child is 19, unless he's a full-time college student attending school at least five months a year. In this case, it extends until age 24 if you pay more than half of his support. He must cross one or the other of these thresholds before his entire trust income is taxed at his own tax rate.
The IRS gives parents the option of claiming their minor dependent's trust income instead. If you elect to do this, you can file Form 8814 with your tax return and include his unearned income on your return. Rules apply as to who is eligible to do this, however. It's only an alternative if your child had no income other than from trust dividends, interest or capital gains, and if his income didn't top $9,500 for the year. There's a downside to doing this, however. It could end up pushing you into a higher tax bracket because the trust fund income is in addition to your own. You may therefore pay a higher percentage in taxes on his money than if your dependent minor had filed his own return and had claimed the income himself. A higher adjusted gross income can also prevent you from claiming certain tax credits and deductions.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.