How Are Revocable and Irrevocable Trusts Taxed?
For the most part, trusts don’t pay taxes on their income, instead passing the income through to the trust beneficiaries. But when they do pay taxes, the tax rates are often higher than those for individual taxpayers. Here’s how this works.
If you are the trustee of your own revocable trust, you use your own Social Security number for your accounts and report the trust income just like your own. If you are not the trustee, some tax specialists advise that the trust should have its own tax identification number (sometimes referred to as an 04 number), but few trustees take this step, since even if they did, the trust grantor would pay taxes on any income.
All irrevocable trusts must obtain their own tax ID number and file their own 1041 tax return to report any income earned. Irrevocable trusts are divided into two types for tax purposes—grantor trusts and non-grantor trusts. Grantor trusts are those in which the creator of the trust—the grantor—retains significant benefits or rights, such as the right to receive all the trust income or change trustees. Grantor trusts file their own informational returns, reporting the trust income, but do not pay any income tax. Instead, they issue a k-1 form to the grantor, akin to a 1099, telling the grantor how much to report on her tax return. (There are arguments that some grantor trusts do not need their own tax ID number or have to file a return, but the standard practice is to do so with all irrevocable trusts.)
Non-grantor trusts, those in which the grantor does not retain significant rights or benefits, still often do not pay income taxes. Like grantor trusts, they must file an annual 1041 tax return, but they only deduct income actually distributed to or used on behalf of any beneficiaries. To the extent they do distribute income, they issue k-1s to the beneficiaries who received the income, who must report it on their income tax returns, whether or not they are the grantor of the trust. The trust then pays taxes on any undistributed income.
By way of example, let’s assume that a trust earns $10,000 in interest and dividends in a year and distributes $1,000 each to five beneficiaries. It will report the full $10,000 of income on its tax return, but deduct the $5,000 it distributed, paying taxes on the remaining $5,000 of income (less certain deductions). It will issue five k-1s, one each to the five beneficiaries, reporting the $1,000 each that they received.
Trust Tax Rates
Trust tax rates follow similar rates to those paid by individuals, but reach those rates at much lower thresholds. Here are the rates and thresholds for 2020:
Taxable Income Tax Rate
$0 – $2,600 10%
$2,601 – $9,450 24%
$9,541 – $12,950 35%
$12,951 and above 37%
As you can see, trusts reach the top rate at just under $13,000 of income. Except for the best heeled trust beneficiaries, their own marginal rates are likely to be much lower, since individuals need more than $500,000 of income and married couples more than $600,000 of income to reach this rate. This means that trusts can usually save taxes by distributing all but minimal income to beneficiaries. Of course, taxes paid is only one consideration in determining whether it’s appropriate to make distributions.