Do Beneficiaries Pay Taxes on Estate Distributions?

When transferring money or property, taxes may apply. Who pays? Are trust distributions taxable to the recipient? Do trust distributions have to be taxable to the trust? Are trust distributions taxable at all?

However, trust administration and taxation are complex subjects, so we wish we had a simple answer. If you need help navigating trust distribution taxes, this article can help you.

However, you should still consult an experienced attorney or accountant to ensure you follow taxation procedures. You must comply to avoid trouble with the IRS and trust beneficiaries. Who might sue you for fiduciary misconduct? Let’s learn about Do Beneficiaries Pay Taxes on Estate Distributions?

Trusts: How They Work

Trusts are legal arrangements in which a settlor (a trustee or grantor) transfers property or money from one person to another to benefit a third party, the beneficiaries.

Most settlers name themselves the trust’s trustee and sole beneficiary for their lives, but this isn’t mandatory. When they become incapacitated or die, the successor trustee will assume the responsibility of supervising the trust and begin carrying out trustee duties. These duties include:

• Collecting trust assets,
• Preparing trust accounting,
• Paying creditors,
• And making payments to beneficiaries from trust funds.

Many reasons explain why trusts are so popular for passing down assets to loved ones. One reason is that trusts usually don’t have to go through probate and can provide creditors with some protection. However, their tax savings are the most important factor for many.

Managing Trusts and Taxes: What Types of Taxes Do Trusts Face?

Often, trusts are subject to the same taxes as individuals. So people often assume all trusts are tax-advantaged and protected from creditors.

Managing Trusts and Taxes.

Trusts may have to pay several types of taxes. However, the type of trust and how the trust is structured determine how a trust is taxed. It’s a good idea to seek the advice of a probate lawyer and a tax professional. If you’re the successor trustee, you follow the trust’s provisions and relevant tax laws as a successor trustee.

As discussed in the sections below, several types of taxes apply to trusts after the settlor dies.

Income Tax

Just as individuals and businesses must pay taxes on their income, trust income must also be taxed. The income taxable by trusts falls into two general categories, each with its own rules: ordinary income taxes and capital gains taxes.

Gift Tax

As of 2023, if an asset is transferred during the lifetime of one individual to another without receiving fair market value from the recipient, the asset may be subject to gift tax, particularly if its value exceeds the $17,000 gift tax exclusion amount.

Gifts of more than $17,000 will count against the federal estate tax exclusion of $12.92 million and the lifetime gift exclusion if more than $17,000 is given yearly to the recipient.

Some trust types are exempt from gift taxes depending on their provisions and structure. An irrevocable charitable trust established to benefit a charitable foundation may be exempt from gift taxes, for example. A qualified terminable interest property trust (QTIP) or a spousal lifetime access trust (SLAT) may also be exempt from tax if they provide income to the surviving spouse during their lifetime.

Consult a tax professional or an attorney if you oversee a trust that qualifies for exemptions.

Estate Tax

The duty of estate tax (or “death tax”) is to tax assets transferred to beneficiaries by a deceased person. Executors and administrators are responsible for paying estate taxes in probate estates. In contrast, the trustee pays the estate tax before transferring assets to beneficiaries if the trust has assets subject to the estate tax.

Generally, trusts will not have to pay estate taxes because estate taxes only apply to decedents’ estates worth $12.92 million or more.

Property Tax

Real estate trusts often own real estate, so the trustee is almost certain to be responsible for paying county and state property taxes on the properties the trust owns.

Upon the trustee’s transfer of real property to its beneficiaries, the beneficiaries will be responsible for paying the property taxes annually until they sell it or transfer it elsewhere.

No specifics on property taxes are available because states and municipalities generally levy them. However, the median property tax in California in 2023 was $3,818.

Depending on the type of trust, you may be exempt from paying property taxes. Seek advice from an experienced lawyer or tax professional if you still need to determine whether your trust qualifies.

Are Beneficiaries Subject to Estate Taxes?

As separate entities, estates must file income tax returns with the IRS. The estate may also owe taxes on income generated through its assets.

A beneficiary shouldn’t worry about taxes if the estate pays the appropriate tax amount. However, if that income has shifted before taxes are collected, the beneficiary is responsible for taxes.

IRA exceptions: With any tax rule, there are exceptions, and the case with Individual Retirement Accounts (IRAs) is no different.

IRA beneficiaries won’t owe income tax on their inheritance in 2022 if the estate value doesn’t exceed $12.06 million, but the IRS will need the required minimum distributions. IRAs require you to take RMDs when you reach 72 (or 70.5 if born before July 1, 1949). Yet an inherited IRA requires you to take RMDs when you reach:

By the end of December, the 10th anniversary of the owner’s death falls. The beneficiaries of an IRA have the right if they are not receiving life expectancy payments. Your taxable income will increase by these distributions on the tax year you make the RMD.

The money in a Roth IRA has to come out eventually. However, you won’t have to pay income taxes when the funds pass through your hands.

Does a Beneficiary have the Right to Refuse a Distribution from a Trust?

Trustees are always entitled to refuse distributions from a trust. If a beneficiary refuses a distribution, ask them to sign a disclaimer so you aren’t liable.

Unless the trust specifically provides otherwise, when a beneficiary refuses a distribution, their inheritance passes to the next in line unless the beneficiary predeceased the settlor.

If a beneficiary refuses a distribution, why? Although it may seem like rejecting free money, there are some valid reasons for doing so. These include:

• The beneficiary may be financially secure and does not require distribution. The best thing they can do is preserve trust assets for their children or grandchildren.
• If the beneficiary received a distribution from trust income instead of trust principal. They would pay taxes at a higher rate, which they try to avoid.
• In response to dissatisfaction with the trust terms, the beneficiary refuses distribution.
• A beneficiary receives a means-based benefit. Which they may lose eligibility for after receiving a distribution.

Trustees who intend to refuse the distribution of trust funds should consult an attorney for a less drastic option if they consider refusing distribution.

Getting Help is Important.

When transferring assets to your loved ones, the best way to minimize taxes is to consult a qualified financial professional or tax expert.

When planning your estate, considering taxes, whether inheritance or state, can help you ensure a greater share of your legacy reaches those you love.