This question comes up frequently when discussing the administration of trusts and estates, and as with many tax questions, the answer is “it depends.”
At the most basic level, distributions of trust or estate principal are not subject to income tax, but income distributions are subject to income tax.
Generally, the principal of a trust or estate is the amount of assets that funded it plus any prior year income previously undistributed.
Since many trusts are created to safeguard assets, they often have strict rules regarding when principal distributions can be made, as decreasing trust principal also reduces the trust’s ability to earn income. It is essential to consult the trust document and your tax advisor to determine if principal distributions are desirable or even allowed in your specific circumstance.
For estates, distributions are assumed to come from principal instead of income if they are specific bequests. Specific bequests are any specific assets given to an individual via inheritance. The asset must be unmistakable, and the intended recipient must also be without question. For example, John leaves $10,000 to his daughter Susan.
Principal distributions are not considered taxable income and beneficiaries will not need to report them on their individual tax returns.
Trust distributions are typically considered to be from current-year income first, then from any accumulated principal if the amount distributed exceeds income for the year. This is also true for estate distributions for the residuary beneficiary of the estate. The residuary beneficiary is the person who receives property by inheritance that is not specifically left to another designated beneficiary.
Like individuals, estates and trusts are required to file a fiduciary income tax return each year income exceeds the annual exemption amount. When these entities make income distributions, they are able to deduct them from the entity income.
The beneficiary of those distributions then receives a Form K-1 from the entity reporting the amount and type of income that was distributed to them, which the individual then needs to include on their tax return.
This “system” ensures that income is either taxed on the entity’s tax return or on the beneficiary’s tax return, but not on both. In many cases, there are benefits to having the income taxed to the beneficiary instead of to the estate or trust.
The tax rates for these entities are the same as for individuals, but the brackets are much narrower, so their marginal tax rates are usually higher. For example, a trust or estate reaches the highest tax bracket of 37% at only $13,450 of taxable income.
Whether the distributions you received are considered principal or income (and how to report properly) depends greatly on your specific circumstances. Contact your SVA advisor to discuss your specific situation.