How are taxes handled in an inherited trust?

Q: My parents passed away years ago and left money in a trust that is now going to be distributed to their grandchildren. How are the taxes normally handled on a trust that originally came down from their grandparents? Can the trust hold funds in an education fund?

– Don

A.: Trusts can help accomplish a lot of goals. Because of this flexibility they can also be complex. I will discuss some basics here, but I am not an attorney and I recommend you engage a good one to assist you.

The trustee is the party that makes decisions on behalf of the trust’s beneficiaries, but the trust document outlines what the trustee can do with the assets in the trust. In some cases, the trust dictates what must be done and in other cases, the trust document outlines the parameters within which the trustee makes decisions about what is paid to whom, for what, and when.

For instance, it is common for trusts to compel the trustee to keep money in trust until a minor reaches adulthood or other specified age. Most trusts allow the trustee to use funds to pay for educational expenses but whether a trustee can place funds in an education specific account like a 529 plan, is dependent upon the language in the trust.

Read: This is the best mix of investments for the long term

Tax wise, generally, if money is paid out to a beneficiary, the earnings attributable to those funds are recorded on the beneficiary’s Form 1040 and the beneficiary is responsible for paying the taxes. If the earnings are retained by the trust, the trustee accounts for this on Form 1041 and the taxes are paid with the trust funds based on the tax schedule for trusts.

The tax schedule for trusts is far less favorable than the schedule for individuals. For instance, for 2020, single filers pay federal tax at a rate of 37% when their taxable income exceeds $518,400. A trust pays tax at a 37% rate above a mere $12,950 of taxable income. This creates a strong incentive to pay earnings to beneficiaries rather than retaining in them in the trust.

Read: I’m 59, and my husband and I earn $500,000 a year — but have credit card debt and nothing saved for retirement. What should we do?

Of course, things are not that simple. Trust accounting can be complex and language in the trust reflecting the grantor’s wishes can easily conflict with the optimal tax structure. Again, conferring with appropriate counsel is wise, especially if you are the trustee. Trustees are personally liable for breaches of their duties to the trust beneficiaries.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you. Some questions are edited for brevity.

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