I inherited money from a trust is it taxable

It might be hard to believe, but amounts received as a gift or inheritance are, regardless of amount, not subject to income tax.  Really.

Now, myriad other taxes imposed on lifetime and testamentary transfers, such as Federal and New Jersey Estate Tax, Federal Gift Tax, New Jersey Inheritance Tax, or Federal Generation Skipping Transfer Tax might have taken a bite out along the way, but the amount that a beneficiary ultimately receives from an estate or trust is not subject to income tax.  Again, this is regardless of amount, so many people simply cannot believe it.

The free ride stops, however, for income earned on the amounts to be inherited.  Estates and Trusts are taxed for income tax purposes under a regime which can best be described as “follow-the-money.”  If any Estate or Trust earns income on assets that it holds, the Estate or Trust pays tax on that income, but if the income is distributed to the beneficiary, the beneficiary pays the tax.  Still, the underlying asset is not subject to income tax, only the income generated by that asset.  For example, if a trust has $1,000,000 invested and earns $50,000, the trust pays income tax on $50,000 if it keeps the income, but the beneficiary pays the tax if that amount is distributed; however, if $100,000 is distributed to the beneficiary, the $50,000 in income is taxable to the beneficiary and the other $50,000 is classified as a gift or inheritance and therefore not subject to tax.

Note that special rules apply for amounts received from so-called “tax-qualified” assets, such as IRAs, 401(k)’s, tax-deferred annuities or other retirement accounts.  Amounts received from those assets, since they have never been subject to income tax, ARE TAXABLE to the beneficiary.  Some relief may exist in the form of an income tax deduction available for any Federal Estate Tax also imposed on the tax-qualified asset at the estate level, so beneficiaries should always request a copy of the Federal Estate Tax Return (if required to be filed) in order to determine whether that deduction is available.

Our next post will address a surviving spouse’s so-called “Elective Share” and “Omitted Spouse” rights.

Inheritance Tax may have to be paid on a person’s estate (their money and possessions) when they die.

Inheritance Tax is due at 40% on anything above the threshold - but there’s a reduced rate of 36% if the person’s will leaves more than 10% of their estate to charity.

Inheritance Tax can also apply when you’re alive if you transfer some of your estate into a trust.

When Inheritance Tax is due

The main situations when Inheritance Tax is due are:

• when assets are transferred into a trust
• when a trust reaches a 10-year anniversary of when it was set up (there are 10-yearly Inheritance Tax charges)
• when assets are transferred out of a trust (known as ‘exit charges’) or the trust ends
• when someone dies and a trust is involved when sorting out their estate

What you pay Inheritance Tax on

You pay Inheritance Tax on ‘relevant property’ - assets like money, shares, houses or land. This includes the assets in most trusts.

There are some occasions where you may not have to pay Inheritance Tax - for example where the trust contains excluded property.

Special rules

Some types of trust are treated differently for Inheritance Tax purposes.

Bare trusts

These are where the assets in a trust are held in the name of a trustee but go directly to the beneficiary, who has a right to both the assets and income of the trust.

Transfers into a bare trust may also be exempt from Inheritance Tax, as long as the person making the transfer survives for 7 years after making the transfer.

Interest in possession trusts

These are trusts where the beneficiary is entitled to trust income as it’s produced - this is called their ‘interest in possession’.

On assets transferred into this type of trust before 22 March 2006, there’s no Inheritance Tax to pay.

On assets transferred on or after 22 March 2006, the 10-yearly Inheritance Tax charge may be due.

During the life of the trust there’s no Inheritance Tax to pay as long as the asset stays in the trust and remains the ‘interest’ of the beneficiary.

Between 22 March 2006 and 5 October 2008:

• beneficiaries of an interest in possession trust could pass on their interest in possession to other beneficiaries, like their children
• this was called making a ‘transitional serial interest’
• there’s no Inheritance Tax to pay in this situation

From 5 October 2008:

• beneficiaries of an interest in possession trust cannot pass their interest on as a transitional serial interest
• if an interest is transferred after this date there may be a charge of 20% and a 10-yearly Inheritance Tax charge will be payable unless it’s a disabled trust

If you inherit an interest in possession trust from someone who has died, there’s no Inheritance Tax at the 10-year anniversary. Instead, 40% tax will be due when you die.

If the trust is set up by a will

Someone might ask that some or all of their assets are put into a trust. This is called a ‘will trust’.

The personal representative of the deceased person has to make sure that the trust is properly set up with all taxes paid, and the trustees make sure that Inheritance Tax is paid on any future charges.

If the deceased transferred assets into a trust before they died

If you’re valuing the estate of someone who has died, you’ll need to find out whether they made any transfers in the 7 years before they died. If they did, and they paid 20% Inheritance Tax, you’ll need to pay an extra 20% from the estate.

Even if no Inheritance Tax was due on the transfer, you still have to add its value to the person’s estate when you’re valuing it for Inheritance Tax purposes.

Trusts for bereaved minors

A bereaved minor is a person under 18 who has lost at least one parent or step-parent. Where a trust is set up for a bereaved minor, there are no Inheritance Tax charges if:

• the assets in the trust are set aside just for bereaved minor
• they become fully entitled to the assets by the age of 18

A trust for a bereaved young person can also be set up as an 18 to 25 trust - the 10-yearly charges do not apply. However, the main differences are:

• the beneficiary must become fully entitled to the assets in the trust by the age of 25
• when the beneficiary is aged between 18 and 25, Inheritance Tax exit charges may apply

Trusts for disabled beneficiaries

There’s no 10-yearly charge or exit charge on this type of trust as long as the asset stays in the trust and remains the ‘interest’ of the beneficiary.

You also do not have to pay Inheritance Tax on the transfer of assets into a trust for a disabled person as long as the person making the transfer survives for 7 years after making the transfer.

Paying Inheritance Tax

You pay Inheritance Tax using form IHT100.

More help and information

There’s more detailed guidance on trusts and Inheritance Tax.

Contact HMRC or get professional tax advice if you need help.