In the big picture, trust disbursements are taxable income to the beneficiaries who received the money. But like all things relating to taxes, it gets more complicated. How much is taxable and at what rate depends on the nature of the trust earnings. If you are a beneficiary, the trustee will provide you with the information you need to complete your income taxes.
Trust Income Tax Return
In the eyes of the government, a trust is a separate legal entity, so the trustee must file a trust tax return using IRS Form 1041. The income a trust earns, such as dividends and interest from investments, is taxable income for the trust. Distributions paid to beneficiaries are deductible against that income. Typically, all of the income earned by a trust is distributed to the beneficiaries so the taxes the trust must pay are reduced. Income not taxed at the trust level becomes taxable income for the recipients of the distributions.
Beneficiary Income Report
The completed Form 1041 trust tax return includes a Schedule K-1 for each beneficiary. This document provides the information you need to complete your personal tax return. The form breaks down the sources of income that the trust earned and passed through as distributions. The K-1 includes separate boxes for different income types such as interest income, ordinary and qualified dividends, capital gains, and rental income.
Nature of Income
A trust beneficiary pays taxes on trust income with rates based on the type of income reported on Schedule K-1. Interest income and ordinary dividends are taxed at your regular income tax rate. Qualified dividends and long-term capital gains will be taxed at the lower rate that applies to those types of income. As of 2013, this lower rate is zero percent for the two lowest tax brackets, 15 percent for the 25 to 35 percent brackets and 20 percent for taxpayers in the highest 39.6 percent regular income tax bracket. Tax-free municipal bond income is not taxed at the trust level and not included in your K-1 income. If the trust earns tax-free interest from investments, the reportable income will be lower than the actual distributions to beneficiaries. The difference represents the amount of municipal bond interest that was paid out.
Paying Your Taxes
If, as a trust beneficiary, you receive taxable income as some or all of your trust disbursements, plan ahead to be able to pay the taxes you owe when you file your return. For larger amounts of trust income, set up a plan to make regular quarterly payments to the Internal Revenue Service to prepay the taxes. You may be able to work with the trustee to set aside money for the taxes or have a portion of the disbursements go directly to the IRS, avoiding the problem of writing a big check when you file your taxes.