Taxes and Beneficiaries: Estate, Income and Capital Gains

Dear Liza:

My aunt died recently, leaving her estate to me and my four siblings, in equal shares. She owned stocks and bonds, and some farmland in Iowa. Will I have to pay taxes on my share of the distributions?

That’s such a good question! You are most definitely not alone — almost everyone who receives an inheritance worries about the tax implications of the gift.

There are actually three taxes to consider here:

  1. The estate tax. If your aunt died in 2017, and owned less than $5.49 million dollars (like most people), her estate would owe no estate tax. That tax falls on the estate, not on the beneficiaries, so, even it were due, the trustee would pay that first, then distribute the assets to you and your siblings. The trust might pay it, then distribute what’s left, or, the trust might pay it, then deduct the tax payment from each distribution, but in your aunt’s case, let’s assume zero tax.
  2. Income tax. Beneficiaries don’t have to pay tax on distributions from the trust’s principal, but they will have to pay income tax on distributions from trust income to the extent that there are distributions to the beneficiaries or in the final year of a trust.  Income tax rates are much more compressed for trusts than for individuals, which means that a trust’s income is taxed at a much higher rate than that same income would be taxed to an individual.  That’s why it is usually better to distribute all the trust’s income out to the beneficiaries so that each beneficiary can pay tax on that income at their lower individual rate. How can you know which distributions are from principal and which are from income? Only the taxable portion of the distribution will be reported on the Form K-1 that you will receive from the trustee.
  3. Capital gains taxes. If your aunt’s assets have gone up in value since she died, and you sell what you’ve inherited from her (like stocks for example), you would have to pay capital gains taxes on the gain since the time of her death.