The Hidden Income Tax Cost of Leaving Wealth in Trust

A trust can protect family wealth, provide for beneficiaries, and preserve assets across generations. But even a carefully designed trust can create substantial income-tax expenses that reduce how much wealth remains for the people it was intended to benefit.

Many families focus on the estate-tax advantages of trusts without considering what happens after assets are transferred into them. Investment accounts continue generating income. Properties produce rent. Businesses make distributions. Appreciated investments are eventually sold.

That income may be taxed very differently depending on the trust’s structure, whether income remains in the trust, and who is responsible for paying the taxes.

For families with substantial assets, the income-tax cost of maintaining a trust can be as important as the estate-tax benefits of creating it.

A Family Trust That Costs More Than Expected

Consider a father who establishes a trust to provide long-term financial security for his two adult children.

The trust holds a $2.5 million investment portfolio. Its provisions allow an independent trustee to make distributions when appropriate while retaining assets for future generations.

The father wants to protect the inheritance from unnecessary spending, potential creditors, and other financial risks. Keeping the money in trust seems preferable to distributing it outright.

Several years later, the portfolio generates approximately $90,000 annually from interest, dividends, and investment gains.

The trustee assumes that retaining most of the income is the best way to preserve the assets. However, the trust’s accountant explains that the retained income may be subject to substantially higher income-tax rates than the beneficiaries would pay individually.

The family now faces an important question: How can the trust continue protecting the assets without unnecessarily reducing their value through taxation?

The answer depends on understanding how trusts are taxed.

Trusts Reach the Highest Income-Tax Bracket Quickly

One of the biggest differences between individual and trust taxation is the amount of income required to reach the highest federal tax bracket.

For 2026, the federal ordinary-income tax rates applicable to estates and trusts range from 10% to 37%.

A nongrantor trust reaches the 37% marginal federal income-tax bracket once its taxable income exceeds $16,000.

By comparison, the 37% bracket for 2026 begins above $640,600 in taxable income for an unmarried individual and $768,700 for married taxpayers filing jointly.

These figures come from the IRS’s 2026 inflation-adjusted tax tables.

The difference is substantial.

If a nongrantor trust retains $80,000 of ordinary taxable income, the amount above $16,000 falls within the 37% marginal bracket. That does not mean the entire $80,000 is taxed at 37%, but the trust reaches that rate much sooner than most individual taxpayers.

The trust may also owe the 3.8% federal net investment income tax on certain undistributed investment income when the applicable thresholds are met.

This compressed tax structure means that a relatively modest amount of retained investment income can create a significant tax obligation.

Grantor Trusts and Nongrantor Trusts Are Different

Not every trust pays income taxes in the same way.

A grantor trust is generally treated as owned by another person, often the individual who established it, for federal income-tax purposes.

In that situation, the grantor reports the trust’s taxable income on their individual return, even when the income remains in the trust.

Many revocable living trusts operate this way during the grantor’s lifetime. Certain irrevocable trusts can also be structured as grantor trusts.

This distinction can be valuable in sophisticated estate and wealth-transfer planning.

For example, when a grantor pays the income taxes attributable to an intentionally structured grantor trust, trust assets may continue growing without being reduced by those tax payments. Under applicable rules, the grantor’s payment of that income-tax liability is generally not treated as an additional taxable gift to the beneficiaries.

However, the structure must be carefully designed. The consequences can change when grantor trust status ends, and provisions concerning tax reimbursement or retained powers may create additional estate-tax considerations.

A nongrantor trust, by contrast, is generally treated as a separate taxpayer. It may pay tax on retained income, while beneficiaries may be responsible for income properly carried out to them through distributions.

Understanding which structure applies is essential before evaluating tax-saving opportunities.

Should the Trustee Distribute Income Instead?

Returning to the family trust, suppose one beneficiary has a successful career and substantial income while the other works in a lower-paying profession.

The trustee might wonder whether distributing some income to the second beneficiary would result in a lower combined tax burden.

In certain circumstances, it could.

For nongrantor trusts, federal income-tax rules generally permit deductions for qualifying income distributions. The corresponding taxable income is reported to beneficiaries through Schedule K-1.

The amount and character of income carried out to beneficiaries are governed by rules involving distributable net income, commonly called DNI.

The IRS Form 1041 instructions explain how income distributions and beneficiary reporting work.

But distributing money does not automatically produce a tax benefit.

A beneficiary may already be in a high tax bracket. A distribution could affect other tax obligations or financial circumstances. More importantly, the trust may have been created specifically to protect the beneficiary from creditors, poor financial decisions, or other risks.

Some trusts also limit distributions to particular purposes, such as health, education, maintenance, or support.

The trustee cannot simply disregard those restrictions to reduce taxes.

A lower income-tax bill is not necessarily worth compromising the protection the trust was designed to provide.

The appropriate decision requires comparing the potential tax consequences with the beneficiary’s circumstances, the trust’s terms, and its long-term objectives.

Capital Gains Create Another Complication

Investment gains can be especially difficult to manage because they do not always follow the same distribution rules as interest and dividends.

When a trust sells appreciated investments, the resulting capital gains are generally allocated to trust principal rather than ordinary accounting income.

Depending on the trust’s provisions, applicable state law, and how distributions are administered, those gains may remain taxable to the trust even when other amounts are distributed to beneficiaries.

For 2026, estates and trusts can reach the 20% federal long-term capital gains rate when taxable income exceeds $16,250. By comparison, individual taxpayers generally have much higher thresholds.

The additional 3.8% net investment income tax may also apply.

This can create substantial tax exposure when a trust sells highly appreciated securities, real estate, or other investments.

For instance, a trustee may want to diversify a concentrated portfolio by selling stock that has appreciated significantly. The investment decision could be entirely reasonable, but the timing and tax consequences deserve examination before the transaction occurs.

Trustees should not assume that distributing the sale proceeds will automatically shift the capital gains tax to beneficiaries.

The treatment depends on the governing documents and applicable tax rules.

Investment and Distribution Decisions Should Work Together

Trustees are responsible for managing trust assets in accordance with their fiduciary obligations. Tax efficiency is relevant, but it is not their only responsibility.

A trust holding substantial investments may need to balance portfolio diversification, income generation, beneficiary needs, and long-term preservation.

An investment producing significant taxable income may be appropriate for one trust but less suitable for another.

Similarly, distributing income may help reduce trust-level taxation in some circumstances but undermine important long-term objectives in others.

The tax treatment of a trust may also depend on its state connections. Trustee residence, the location of administration, and other factors can affect state income-tax obligations.

Miller Legal Group discusses these issues in Trust Situs and State Tax: Why Location Still Matters in Estate Planning.

For families with substantial assets, income-tax planning should therefore be coordinated with investment management, fiduciary responsibilities, and the trust’s intended purpose.

When Should an Existing Trust Be Reviewed?

An existing trust deserves particular attention when its assets have appreciated substantially, its investment strategy has changed, or its annual income-tax obligations have increased.

A review may also be appropriate when beneficiaries experience significant changes in their financial circumstances, a grantor dies, a successor trustee begins serving, or trust administration moves to another state.

The review should consider the trust’s current tax classification, income sources, distribution provisions, capital gains treatment, and the tax circumstances of its beneficiaries.

In some cases, better coordination among the trustee, legal counsel, investment adviser, and tax professional may identify practical improvements without changing the trust itself.

Other situations may justify examining whether legally permissible administrative changes or more substantial modifications could improve its effectiveness.

Those decisions should be made carefully because changing an irrevocable trust can introduce separate gift-tax, estate-tax, and beneficiary-rights issues.

Protecting Wealth Means Paying Attention to What the Trust Keeps

A trust’s success should not be measured solely by the assets transferred into it or the estate taxes it may help avoid.

The income taxes paid during administration can affect how much wealth ultimately remains for beneficiaries.

Trusts can provide valuable protections that justify retaining assets even when doing so creates additional tax costs. The objective is not necessarily to minimize taxes at every opportunity. It is to understand those costs and avoid unnecessary taxation while preserving the trust’s intended benefits.

Miller Legal Group advises families, trustees, and beneficiaries on sophisticated trust and tax-planning strategies, including the interaction of income taxation, asset protection, and long-term wealth preservation.

If an existing trust generates substantial income or its tax obligations have increased, contact Miller Legal Group to discuss whether its current structure and administration remain appropriate for your family’s objectives.