It is very common for our clients to express confusion about the taxation of estates and trusts. That’s because it’s confusing.
Taxation of estates can be any of at least four types of tax
Look online for information about taxation of estates and you’ll get a boatload of information about the estate tax. But that turns out to be the least important type of tax to consider — at least for most people.
Estate taxation doesn’t kick in until a decedent leaves a very large amount of money (or property, or life insurance, or … but we’re getting away from ourselves here). Next year (2026), for example, the estate tax doesn’t even kick in until the decedent leaves $13.99 million. Double that for a married couple.
We’re going to mostly ignore the estate tax, but before we do, there are couple of caveats to share:
- If your property isn’t in Arizona (or you lived in another state), your estate might actually owe a state estate tax. Not in Arizona, though. So we’ll skip the details for now. But ask us if this worries you.
- The $13.99 million level assumes that you haven’t made large lifetime gifts. If you have, you might have used up some of the $13.99 million exemption.
- Married couples get to double that amount! Well, not exactly — but if one spouse dies the survivor gets to hold onto the deceased spouse’s exemption amount in the year of the deceased spouse’s death.
- There’s actually a big change impending. At the end of 2025, the exemption amount is scheduled to drop to half what it will be for all of 2025. But there are about a gazillion words written on this subject online, so we’ll skip it for now. It’s important — but not all that important for people who are unlikely to be worth more than about $7 million (double that for a married couple) when they die.
OK — what about income taxation of estates? And trusts?
First, a quick explanation. Inheriting money is not an income taxable event. Well, it almost never is, anyway. If your mother leaves you a million dollars, or your great-aunt gives you $15,000 in January, you pay no income tax on that money. Also, incidentally, they don’t get to deduct the gift from their own income tax. Gifts and bequests are largely income tax neutral.
Another important rule to touch on here: if you set up a revocable trust while you are alive, the trust will be ignored for your own income tax liability. No, we don’t mean you don’t have to pay tax on it — we mean that you pay tax on the trust’s income as if there was no trust. And if the trust is irrevocable? Well, pretty much the same rule. Most of the time, anyway. So setting up a trust during your life, and dying with either a trust or an estate, are untaxable events, at least for income tax purposes.
Except when they aren’t. This is the hardest thing to explain about taxation of estates and trusts. If you receive distributions from a trust or estate, there might be an element of taxable income included. Let’s explain with an example.
The taxable portion of distributions from trusts and estates
Suppose your wealthy aunt died, leaving you her entire estate. We’ll assume that there is no trust involved — at least for the moment. But there is a $1 million brokerage account. And you’re the sole beneficiary of her estate! We’re sorry about your favorite aunt, but hey — you’re going to receive $1 million!
As it happens, she died in March of 2024. And it’s taken several months to get her estate wrapped up. Meanwhile, her assets have been earning income, and they have also grown in value. In fact, there’s about $20,000 of interest and dividends, and a 10% increase in the value of her investments.
Now suppose that her executor (we actually call them “personal representative” now) is ready to make a partial distribution to you this month. You’re going to receive $200,000 within the next few weeks.
What are the tax consequences? Well, the distribution will “carry out” the $20,000 of income. So you’ll owe income taxes on that portion of the distribution. But the capital gains don’t get taxed unless the estate liquidates some or all of the assets. So you and the personal representative should have a discussion about your choices. You could:
- Take the stock directly. There’s no tax on the stock distribution itself — though even if you take no cash at all you still owe the income tax on that $20,000 of income. Later, when you sell any of the stock, you’ll owe income tax on the capital gains between your aunt’s death and the date of sale.
- Ask the executor to liquidate the stock and give you cash. Now you don’t pay any income tax on the capital gains. But the estate does! And its tax rate is almost certainly higher than yours. Since you’re the sole recipient, that means you effectively pay a higher tax.
- Talk to the personal representative about electing to treat the estate’s capital gains as income. It’s a technical choice that really will benefit from a discussion among you, the personal representative, the lawyers and your Certified Public Accountant (CPA).
Ack! It’s getting near the end of the tax year!
Here’s a surprise bit of good news: you may not owe any tax on income distributed to you this year until 2026!
How does that work? Well, the estate can elect to file its income tax return for the year ending in February, 2025 (11 months+ after your aunt’s death). And that means that even though you receive money now, you don’t get tax filings until sometime after the end of February. So your income will be received in your calendar year 2025, and the tax liability will come due in April, 2026.
Again, talk to your CPA. And your lawyer.
What if my aunt had created a trust? Or named me as beneficiary?
For a trust: pretty much the same answers. In fact, your aunt’s trust could probably elect to be treated as if it were an estate for these purposes.
For beneficiary designations: you get to file the income tax forms yourself, since the change to your name happened as of the date of your aunt’s death. Of course, things can be very different in individual cases, but that’s why you’re getting good legal and tax advice!
Are the rules the same for every kind of asset?
No, of course not. That would be too easy. Some of the more common asset types that get special treatment:
- Retirement accounts. IRAs, 401(k)s and most other types of retirement accounts follow their own rules. Whoever takes out the money pays the income tax. The biggest issue for retirement accounts is usually figuring out how quickly the money has to be withdrawn.
- Life insurance. Life insurance is not taxable to the beneficiaries at all. So no income tax — and no estate tax, either. Even if the estate is large enough to incur the estate tax, that is paid by the estate, not directly by the beneficiaries.
Can we complicate this, please?
Of course!
Suppose your aunt left her estate to you, your brother and sister, in equal shares. And her estate consists of her brokerage account (worth $1 million), her retirement account (worth, coincidentally, $1 million), and her home (conveniently worth $1 million).
First, note that you probably don’t have to have all her disparate assets liquidated before distribution. And you don’t have to distribute each asset in equal shares, either. In most cases, the beneficiaries can agree to divide the assets any way they choose. They might not even need to require appraisals, strict fairness or other legal niceties.
But back to the taxation of estates angle here: Suppose you and your siblings agree that they will divide your aunt’s investments and you will take her house. In order to make it work, things will need to be liquidated. And that means income generated on the sale(s), plus that $20,000 of investment income.
But you’re not getting any of the stock or other investments. So you shouldn’t pay any of the income taxes, right? Wrong. You are liable for 1/3 of the income tax effect even if you didn’t get any cash or investments.
We do hope this makes the process a little easier to understand. And we hope that you see that you’re going to need to talk to your CPA and your lawyer about the tax effect of the choices you’re facing.
