What Happens when you Inherit Money from a Trust?
Posted on May 1, 2024 by Katherine Fox.
What Happens when you Inherit Money from a Trust?
What happens when you inherit money from a trust depends on the type of trust you are inheriting from and the provisions the grantor (the person who wrote the trust) included.
What happens when you inherit money from a trust?
There are two ways to inherit money from a trust: outright or in trust.
If you inherit money outright it means a distribution is yours to spend, save, or invest as you see fit.
If you inherit money in trust, assets will be controlled by the trustee, although you have the right to access them under specific circumstances dictated by the trust document.
If you have, or expect to, inherit money from a trust, reach out to Katherine to learn how a financial advisor for inheritors can help you understand and manage your inheritance.
How are trust assets distributed to beneficiaries outright from a trust?
If you inherit money outright from a trust, it means the grantor, or person who wrote the trust, used a trust as part of their estate plan. The trust had specific provisions for distributions to beneficiaries when the grantor died that are now being carried out.
If you inherit outright from a trust you may receive:
Stock
Cash
Real Estate
Collectibles
Illiquid assets
How you receive your inheritance distribution depends on the terms of trust from which you are inheriting. These terms could dictate:
Whether assets have to be sold before they are distributed, or if they can be transferred in-kind to beneficiaries.
If beneficiaries have to meet any specific conditions before receiving distributions from a trust.
If certain beneficiaries are set to receive specific trust property or if assets are to be distributed equally based on a percentage allocation between heirs (i.e., 50/50).
What Happens when you Inherit Money from a Trust?
When you inherit money from a trust, it will either be distributed to you outright or held in trust for your benefit. How you get money from a trust as a beneficiary will depend on the terms of the trust, the preferences of your trustee, and what assets the trust holds and is distributing.
How do trust beneficiaries get money from a trust?
1. Three ways irrevocable trust assets can be distributed to beneficiaries:
Lump-sum payments made per the terms of the trusts when beneficiaries attain certain ages or reach life milestones, such as graduating college.
Incremental payments throughout the years, often distributions of all trust income.
Additional distributions at the trustee’s discretion, often made according to the standard of providing for beneficiaries health, education, maintenance, and support (HEMS).
2. Trust distributions may be made in-kind (assets will be transferred directly to you and you are responsible for selling them) or in cash.
In-kind distributions will be transferred to an appropriate account (i.e., a brokerage account for stocks) or through a title transfer in the case of property.
Cash distributions may be paid by check or via wire transfer or ACH to your bank account on file with the trustee.
3. Required income payments to trust beneficiaries will be made regularly.
Beneficiaries who are entitled to income payments from a trust will receive regular payments, generally monthly or quarterly, to their account of choice.
4. Beneficiaries who are not entitled to distributions of trust principal or income will need to make a written request to the trustee for funds.
Often, the trustee will require substantiating documentation before approving a distribution. This documentation may include:
Pay stubs
Annual budget
Housing expenses
Other income/expense information
A description of what you are requesting trust funds for and why it is necessary
How are trust assets distributed to beneficiaries in trust?
If you inherit money held in trust, it means the trust grantor who died had either:
A revocable trust that became irrevocable upon their death.
An irrevocable trust in place already as part of their estate plan.
In either case, inheriting money held in trust means you will not receive an outright distribution of your inheritance to manage and spend yourself. Instead, you will have some right to use trust funds for specific purposes.
In this situation, the criteria for distributions will be laid out in the trust document. This criteria for distributions may be complicated or simple, but will generally include the following:
If beneficiaries have the right to access to trust principal (the main portion of trust investments) or only to access income (the income those investments generate).
In the case of real estate, if beneficiaries have the right to live in or vacation at a property.
If beneficiaries will receive full or partial outright distributions at a certain age or when certain conditions are met (i.e., graduating college).
What standard the trustee should use when determining if beneficiaries can access funds. The standard generally used is “Health, Education, Maintenance, and Support” or HEMS. HEMS allows trustees broad powers to provide for beneficiaries at their current standard of living.
How are trust distributions to beneficiaries taxed?
When taking distributions from an irrevocable trust, withdrawals of trust principal may be non-taxable to beneficiaries while withdrawals attributed to trust income will be taxable.
Think of it this way:
If you put $10 million into a trust today that $10 million is the trust principal.
If, in a year, $10 million has grown to $11 million, that $11 million is the new trust principal.
If, in the same year the $11 million trust generated $100,000 in interest income, that $100,000 is the trust income.
If you are a trust beneficiary who has a right to all income from a trust, you will be responsible for paying taxes on income distributions as ordinary income.
If you are a trust beneficiary who has the right to take distributions of principal under the HEMS or another standard, you may or may not pay taxes on these distributions depending on:
If state law and the trust document allow beneficiaries versus the trust to pay taxes on principal distributions.
If assets are sold to transfer cash or if you receive a distribution of assets in-kind.
In either case, the character of trust distributions will flow through to your income tax return. If a trust distributes $150,000 in a year and:
$100,000 was from trust interest income
$50,000 was from trust principal
Depending on state law, you would pay taxes on $100,000 of trust interest income as ordinary income and $50,000 would be non-taxable to you - taxes have already been or will be paid by the trust.
How are trust distributions taxed from a revocable trust?
Irrevocable trust distributions are taxed on the same schedule regardless of where the irrevocable trust originated.
Beneficiaries inheriting from a deceased person who had a revocable trust may inherit funds with little to no embedded capital gains if trust assets received a step-up in basis.
If the person you are inheriting from had a revocable trust, the trust would have been included as part of the overall estate.
This inclusion means generally means the trust will:
Be included in the estate for purposes of the estate tax calculation, if applicable.
Receive a step-up on the basis to the asset’s value on the deceased person’s date of death.
A "step-up in basis" refers to a tax benefit occurring when someone inherits an asset, such as real estate, stocks, or other investments, from a deceased individual. In this case, it means assets inherited through a revocable trust may have new cost basis values as of the deceased person’s date or up to six months after.
Using the step-up in basis, trust beneficiaries who receive distributions from a revocable trust will likely have little to no capital gains tax due if they sell assets immediately after inheriting.
Is a final inheritance from a trust taxable income?
Beneficiaries receiving final distributions from a trust may or may not owe taxes on that distribution.
Whether or not beneficiaries pay taxes will depend on:
If assets are distributed in-kind (i.e., stocks, real estate, or other assets owned by the trust are transferred to the name of the beneficiary but not sold).
If assets are sold and short or long-term capital gains taxes are realized, whether the trust document and applicable state and federal laws together suggest the trust or the beneficiaries are allowed to pay those taxes.
Remember, regardless of whether the trust or beneficiaries pay taxes on realized capital gains, the taxes will be paid.
Individual tax rates are generally preferred to trust tax rates because trust brackets for each tax rate are smaller, meaning a trust hits the top federal estate tax rate at a much lower amount than individuals. For example, in 2023 a trust will hit the top Federal tax rate at $14,451 or more of income while a married couple filing jointly would hit the top Federal tax rate at $693,750 or more in income. This may make it preferable for beneficiaries to pay taxes if possible, to increase the after-tax value of their inheritance.
Let’s take the next step together
Understanding what happens when you inherit money from a trust is not easy. Beneficiaries can encounter a wide variety of different situations requiring knowledge and finesse to manage. If you need more help, you can download The 20 Inheritance Terms you need to Know, or reach out to Katherine Fox, CFP® and CAP®, a financial planner for inheritors to learn how Sunnybranch can help you build a plan to manage your inheritance from a trust.