Overview of California Inheritance Tax
In California, there is no state inheritance tax. This means that when you inherit assets from a deceased person, you do not owe any tax to the state of California on those inherited assets.
To avoid estate tax, you can set up a trust for your children, and put small amounts of money in it over time. Since they are not inheriting that money, they don't have to pay estate tax on it. They would, however, be subject to income tax on any money that goes to them.
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.
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.
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.
Key Takeaways. Funds received from a trust are subject to different taxation rules than funds from ordinary investment accounts. 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.
A beneficiary of a trust is a person who by the terms of the trust has the current or future right to have the trustee pay out cash or other trust property to him or her. He or she is one of the people for whom the trust was established.
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.
Many people worry about the estate tax affecting the inheritance they pass along to their children, but it's not a reality most people will face. In 2025, the first $13,990,000 of an estate is exempt from federal estate taxes, up from $13,610,000 in 2024. Estate taxes are based on the size of the estate.
The trust fund loophole refers to the “stepped-up basis rule” in U.S. tax law. The rule is a tax exemption that lets you use a trust to transfer appreciated assets to the trust's beneficiaries without paying the capital gains tax. Your “basis” in an asset is the price you paid for the asset.
It is not unusual for the successor trustee of a trust to also be a beneficiary of the same trust. This is because settlors often name trusted family members or friends to both manage their trust and inherit from it.
The grantor can set up the trust so the money is distributed directly to the beneficiaries free and clear of limitations. The trustee can transfer real estate to the beneficiary by having a new deed written up or selling the property and giving them the money, writing them a check or giving them cash.
This means that when the beneficiary withdraws those monies from the accounts, the beneficiary will receive a 1099 from the company administering the plan and must report that income on their income tax return (and must pay income taxes on the sum).
Beneficiaries pay taxes on the income they receive from the trust. Capital gains are not considered income to such an irrevocable trust. Instead, any capital gains are treated as contributions to principal.
Trusts offer amazing benefits, but they also come with potential downsides like loss of control, limited access to assets, costs, and recordkeeping difficulties.
Making a will to distribute your assets
Whether leaving assets to a spouse or civil partner, distributing assets to take advantage of tax-free allowances, or making gifts to charity, a valid will could help you to reduce or avoid Inheritance Tax altogether.
There are a variety of assets that you cannot or should not place in a living trust. These include: Retirement accounts. Accounts such as a 401(k), IRA, 403(b) and certain qualified annuities should not be transferred into your living trust.
Taxation of income
The income generated by the trust assets must be reported on the trust's tax return, Form 1041. The trust itself is responsible for paying taxes on this income unless the income is distributed to beneficiaries.
A good first step for the beneficiary is to meet with the trustee who is tasked with executing the terms of the trust. It may be an individual, such as a CPA or lawyer, family member, or potentially a corporate trustee such as Wells Fargo Bank.
Parents often make the mistake of choosing a trustee based solely on personal relationships without considering their financial acumen, integrity, and willingness to serve. Choosing one of the children is not always the best choice as other beneficiaries may see their role with suspicion.
Beneficiaries of a trust are usually only taxed on the earnings portions of their distributions, and whether those earnings are taxed as income or capital gains depends on how they were earned. Who pays those taxes depends on how the trust was set up. Estate planning can be complicated, so it pays to be prepared.
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%.
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.