The amount of federal tax a trust beneficiary pays depends on many factors, which include the type of trust, the amount received by the beneficiary, what assets the trustee sold to pay the beneficiary and the terms of the trust. The first step in determining tax treatment for a beneficiary withdrawal is a review of the trust agreement.
In a revocable trust, the grantor that established the trust is the trust beneficiary. When the grantor created the trust, he funded the trust with after-tax funds. In a grantor trust all interest and capital gains earned by the trust tax to the trust grantor. If the trust grantor takes principal cash as a withdrawal, then no additional tax is due on the funds since tax payments occur annually on trust earnings.
Net Income Irrevocable Trust
If an irrevocable trust beneficiary receives net income or the interest and dividends earned by a trust, he will receive a tax Form K-1 each year to report on his federal income tax return. Interest and dividends will tax to the trust beneficiary as income, and he is required under the Internal Revenue Code to pay tax on these amounts. If a beneficiary is receiving large income amounts, it is a wise idea to consult with a tax professional to determine if the beneficiary should make estimated tax payments throughout the year. If the beneficiary earns enough income and does not pay estimated tax payments, he could create a tax penalty situation with the Internal Revenue Service.
A review of the trust agreement must occur to determine if an irrevocable trust beneficiary receives capital gain distributions. Some trust agreements state that any earnings from securities sales that create capital gains distribute to the trust beneficiary as earnings and if so, then the beneficiary is required to pay tax on the capital gains unless the trust agreement states that payment of the tax is from the trust.
If an irrevocable trust beneficiary takes a principal withdrawal and the trustee sells securities to raise the necessary cash, then the beneficiary owes tax on the capital gains. The amount of capital gains the beneficiary will owe tax on is limited to the amount of the distribution. For example, assume a beneficiary received $250,000 to purchase a home and the trustee sold securities for cash. The sell of securities creates capital gains of $125,000, so the beneficiary tax letter form K-1 will show capital gains of $125,000 that he must report on his federal income tax return.