The beneficiary owes income tax on the money if the funds are deemed as having come from the trust's earnings on its assets. Whether the money is taxed as regular income or capital gains depends on the nature of the funds, such as whether the money is cash or dividends.
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.
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.
COMMENT: If all the income is distributed to the beneficiaries, the beneficiaries pay tax on the income. Resident beneficiaries pay tax on income from all sources. Nonresident beneficiaries are taxable on income sourced to California.
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.
The other situation in which assets can be transferred out of an irrevocable trust is when you and any other beneficiaries get together, agree that assets need to be transferred out, then petition a court to do so. Depending on the documents of your trust, the trustee might need to be involved, as well.
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.
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.
There is no federal tax for beneficiaries of POD accounts. There will be an inheritance tax, or death tax, depending on the state, that will need to be settled before any money can leave the account. If the deceased has any debt that has not been settled, the money in the account must go to paying that off first.
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.
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.
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%.
Beneficiaries of an inheritance in California typically do not have to pay income taxes on the inherited assets. That is because inherited assets are generally not taxable income for individual beneficiaries.
Once any trust income has been accumulated by the trustees and is subsequently paid out to beneficiaries, such receipts by the beneficiaries are treated as distributions of capital, not income.
A distribution is a payment from a trust to a beneficiary and may be part of the income and/or capital of the trust.
Bottom Line. California doesn't enforce a gift tax, but you may owe a federal one. However, you can give up to $19,000 in cash or property during the 2025 tax year and up to $18,000 in the 2024 tax year without triggering a gift tax return.
While beneficiaries don't owe income tax on money they inherit, if their inheritance includes an individual retirement account (IRA), they will have to take distributions from it over a certain period and, if it is a traditional IRA rather than a Roth, pay income tax on that money.
Strategies to transfer wealth without a heavy tax burden include creating an irrevocable trust, engaging in annual gifting, forming a family limited partnership, or forming a generation-skipping transfer trust.
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.
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.
The ability of a beneficiary to withdraw money from a trust depends on the trust's specific terms. Some trusts allow beneficiaries to receive regular distributions or access funds under certain conditions, such as reaching a specific age or achieving a milestone.
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.
Irrevocable trust distributions can vary from being completely tax free to being taxable at the highest marginal tax rates, and in some cases, can be even higher. Therefore, understanding the tax implications is critically important—which is why we focus on irrevocable trusts in the discussion below.
If the trustee is not paying beneficiaries accurately or on time, legal action can be taken against them.