Beneficiaries of a trust typically pay taxes on distributions they receive from the trust's income. However, they are not subject to taxes on distributions from the trust's principal.
Transferring assets to a revocable trust will remove those assets from your estate for state probate law purposes but not for federal (or state) estate tax purposes. For estate tax purposes, the value of your "gross estate" will determine the amount of estate tax due at your death.
Assets in a revocable living trust get a step-up in basis at the grantor's death just like if they were owned directly by the decedent. The step-up in basis can eliminate capital gains tax on appreciated assets as heirs can sell those assets with little to no capital gains tax since the basis is adjusted.
Generally, beneficiaries do not pay income tax on money or property that they inherit, but there are exceptions for retirement accounts, life insurance proceeds, and savings bond interest. Money inherited from a 401(k), 403(b), or IRA is taxable if that money was tax deductible when it was contributed.
The grantor can opt to have the beneficiaries receive trust property directly without any restrictions. The trustee can write the beneficiary a check, give them cash, and transfer real estate by drawing up a new deed or selling the house and giving them the proceeds.
Trust beneficiaries must pay taxes on income and other distributions from a trust. Trust beneficiaries don't have to pay taxes on principal from the trust's assets. IRS forms K-1 and 1041 are required for filing tax returns that receive trust disbursements.
The IRS considers revocable living trusts disregarded entities for tax reporting purposes, meaning the income or capital gains of a revocable living trust pass through to the grantor's personal tax return (IRS Form 1040).
Another key difference: While there is no federal inheritance tax, there is a federal estate tax. The federal estate tax generally applies to assets over $13.61 million in 2024 and $13.99 million in 2025, and the federal estate tax rate ranges from 18% to 40%.
The main disadvantage of a revocable living trust is that it does not protect you from creditors or lawsuits. Because you have control of everything in your trust and have access to the assets, you can still be sued for liability.
An irrevocable trust transfers asset ownership from the original owner to the trust, with assets eventually distributed to the beneficiaries. Because those assets don't legally belong to the person who set up the trust, they aren't subject to estate or inheritance taxes when that person passes away.
Can a Revocable Trust Avoid Capital Gains Tax? A revocable trust does not avoid capital gains tax because the trust's creator still owns the assets held in the trust. This means that any profits or losses generated by the assets in the trust are still taxable to the original owner.
Typically this comes in the form of income taxes which either the trust pays or your heirs pay when they receive distributions. You can mitigate that through the use of an intentionally defective grantor trust, or IDGT. This is an irrevocable trust into which you place assets, again shielding them from estate taxes.
Revocable Trusts
The assets in a revocable trust are typically distributed upon the grantor's death. However, the grantor may also choose to distribute assets during their lifetime, subject to the trust distribution provisions of the trust agreement.
Upon your death, the trustee is generally directed to either distribute the trust property to your beneficiaries, or to continue to hold it and manage it for the benefit of your beneficiaries.
When a portion of a beneficiary's distribution from a trust or the entirety of it originates from the trust's interest income, they generally will be required to pay income taxes on it, unless the trust has already paid the income tax.
Q: Do trusts have a requirement to file federal income tax returns? A: Trusts must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year where the trust has $600 in income or the trust has a non-resident alien as a beneficiary.
Any income generated by a revocable trust is taxable to the trust's creator (who is often also referred to as a settlor, trustor, or grantor) during the trust creator's lifetime. This is because the trust's creator retains full control over the terms of the trust and the assets contained within it.
Selecting the wrong trustee is easily the biggest blunder parents can make when setting up a trust fund. As estate planning attorneys, we've seen first-hand how this critical error undermines so many parents' good intentions.
A: Property that cannot be held in a trust includes Social Security benefits, health savings and medical savings accounts, and cash. Other types of property that should not go into a trust are individual retirement accounts or 401(k)s, life insurance policies, certain types of bank accounts, and motor vehicles.
Gifts and inheritance Personal income types
If you received a gift or inheritance, do not include it in your income. However, if the gift or inheritance later produces income, you will need to pay tax on that income.
When you inherit money and assets through a trust, you receive distributions according to the terms of the trust, so you won't have total control over the inheritance as you would if you'd received the inheritance outright. A trustee, who is named by the person who set up the trust, oversees the trust and manages it.
Gifts in trust are commonly used to pass wealth from one generation to another by establishing a trust fund. Typically, the IRS taxes the value of a gift being transferred up to the annual gift tax exclusion amount. A gift in trust is a way to avoid taxes on gifts that exceed the annual gift tax exclusion amount.