Tax Consequences of an Inheritance From an Irrevocable Trust

Whether you must pay taxes on the inheritance from an irrevocable trust depends on the terms of the trust and the state in which it was created. Most people inherit assets from irrevocable trusts that only became irrevocable upon the creator’s demise. In this situation, if you must pay taxes, they are levied at the same rate as any other type of inherited asset. Taking the time to identify the tax consequences of an irrevocable trust is critical.

Most trusts are set up as inter vivos, or revocable living trusts, during the grantor (the creator's) lifetime. In most revocable trusts, the grantor is also the trustee – the person managing the trust’s assets. While the grantor is still alive, he or she can transfer assets in and out of the trust and buy and sell trust assets. During the grantor’s lifetime, the trust’s income is reported on the grantor's income tax returns.

However, when the grantor dies, the revocable trust becomes irrevocable and cannot be changed. These trusts are designed to terminate upon the grantor’s death, at which time, the assets are distributed to beneficiaries. Those assets are valued as of the grantor’s death date. There are no particular tax advantages to a revocable trust, but the trust does not go through probate. This allows for a greater amount of privacy for the trust’s beneficiaries.

Some trusts are set up from the beginning as irrevocable and must file their own tax forms annually. The grantor transfers assets to the irrevocable trust but cannot change or modify the trust afterward. During their lifetime, grantors may receive income from the trust, but they cannot buy or sell assets.

An irrevocable trust is set up for the trust’s beneficiaries, and the amount put in the trust is not considered part of the grantor’s estate. Irrevocable trusts are usually designed to lower estate taxes or protect assets from the grantor’s creditors. Complex irrevocable trusts do not end at the grantor’s death, so there is no inheritance at that time. Should the trust not end but continue making distributions to a beneficiary, these funds are treated as taxable income and are taxed at the beneficiary’s income tax rates.

The grantor may set conditions for the timing of distributing assets from an irrevocable trust. For example, the grantor may decide that beneficiaries cannot receive assets until they reach the age of 30 to prevent a young beneficiary from misusing the income.

For persons who died in 2017, the federal estate tax exemption is $5.49 million. Above that amount, the remaining assets are taxed at a rate of 40 percent. This is not an issue for trusts set up as irrevocable, but it is for those that become irrevocable at the grantor’s death. However, even if you inherit more than $5.49 million from the trust, it is the trust itself that pays the federal estate tax, not the inheritor. Some states have an estate tax, but again, this money is paid by the estate, not the inheritor.

Several states also impose an inheritance tax, although whether or not you must pay such a tax depends on your relationship to the decedent. Irrevocable trust beneficiary taxes differ significantly from state to state. If you are a lineal heir, such as a child or grandchild, you may not have to pay an inheritance tax. If you are not a lineal heir, such as a niece or nephew or are not related to the decedent, higher inheritance tax rates are likely. For 2017, the following states imposed an inheritance tax:

•                Iowa
  
•                Kentucky
  
•                Maryland
  
•                Nebraska
  
•                New Jersey
  
•                Pennsylvania

IRS Form 1040 can be used to report all relevant information pertaining to any assets or income you have received as part of your beneficiary role.