A discretionary trust that keeps its income pays federal tax under the most compressed rate schedule in the code: the top 37% rate kicks in at roughly $16,150 of taxable income for 2026, a threshold an individual filer wouldn’t reach until income passed $626,350.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 That single fact drives almost every tax decision a trustee makes. Distributing income to beneficiaries shifts the tax to their personal returns at usually lower rates; retaining it leaves the trust exposed to the full compressed schedule. Everything below explains how the discretionary trust tax works in practice, and where the traps sit.
Grantor or Non-Grantor: Answer This First
The tax treatment of a discretionary trust depends entirely on whether the person who created it kept certain powers over the property. If the settlor retained the right to revoke the trust, swap assets, control who benefits from income, or hold a reversionary interest, the IRS treats it as a grantor trust. In that case the trust is invisible for income tax purposes. Every dollar of income, gain, and deduction lands on the settlor’s personal return, and the compressed trust brackets don’t apply at all.2Internal Revenue Service. Foreign Grantor Trust Determination – Part II – Sections 671-678
A non-grantor discretionary trust is the opposite. The settlor gave up control and beneficial interest, and the trust becomes its own taxpayer with its own tax ID, its own return, and its own bracket schedule. Everything that follows assumes a non-grantor trust, because that is where the tax pressure lives.
What the Trust Pays on Income It Keeps
When a non-grantor discretionary trust earns income and the trustee decides not to distribute it, the trust itself pays the tax. For 2026 the 37% marginal rate hits at about $16,150 of taxable income.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
Layer on the 3.8% Net Investment Income Tax. NIIT applies to undistributed net investment income once the trust’s adjusted gross income exceeds the dollar amount at which the top ordinary bracket starts.3Internal Revenue Service. Topic No. 559, Net Investment Income Tax The combined federal rate on retained investment income can therefore exceed 40% before any state tax.
A concrete example. A discretionary trust that accumulates $50,000 of interest income during 2026 owes 37% on almost the entire amount plus NIIT on the undistributed portion. Federal tax alone runs near $20,000. That is the arithmetic that pushes most trustees to distribute rather than accumulate.
The trust reports its income, deductions, and liability on Form 1041, the U.S. Income Tax Return for Estates and Trusts.4Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts Anything not distributed by year-end (or within the 65-day window below) is taxed on that return at the trust’s compressed rates.
How Distributing Income Shifts the Tax
Distributing income is the main tool for escaping the trust’s rate schedule. When a trustee distributes income to a beneficiary, the trust claims a deduction for the amount distributed and the beneficiary picks up the income on a personal Form 1040. The income is taxed once, at the beneficiary’s marginal rate, not the trust’s.
The ceiling on how much of any distribution counts as taxable income to the beneficiary is set by Distributable Net Income, or DNI. DNI is essentially the trust’s net taxable income for the year with certain adjustments. It caps both the trust’s distribution deduction and the amount the beneficiary must report.5eCFR. 26 CFR 1.643(a)-0 – Distributable Net Income; Deduction for Distributions; In General Anything distributed above DNI is treated as principal and is not taxable to the beneficiary.
The character of the income passes through. If the trust earned $30,000 of qualified dividends and $10,000 of interest and distributed the full $40,000, the beneficiary reports $30,000 as qualified dividends (at the preferential rate) and $10,000 as interest. The trust reports each category on a Schedule K-1 (Form 1041) issued to the beneficiary.6Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts – Schedule K-1
The savings can be large. If the trust retains that $40,000, federal tax runs near $15,800. Push the same $40,000 out to a beneficiary in the 12% bracket and federal tax on the same dollars is closer to $4,800. This is the single biggest lever a trustee controls.
Principal distributions (the original assets, plus income that was already taxed at the trust level in prior years) are generally not taxable to the beneficiary. The trustee has to track and label them accurately on the K-1, because mislabeling creates reporting problems for everyone downstream.
The 65-Day Election
Trustees rarely know the full year’s income picture on December 31. A distribution made in January or February often makes more sense once the numbers are settled. The Section 663(b) election lets the trustee treat distributions made during the first 65 days of the new tax year as if they occurred on the last day of the prior year.
The election is made on the trust’s Form 1041 for the year to which the distribution is being pulled back. The result is that the trust claims the distribution deduction for the prior year and the income shifts to the beneficiary’s return for that year. It’s the most useful tool for years when income spikes late and there was no time to distribute before year-end. Trustees who forget the election exists can pay thousands in trust-level tax that a timely January distribution would have avoided.
Capital Gains Usually Stay With the Trust
When the trust sells an appreciated asset, the gain is generally taxed to the trust rather than the beneficiaries. Capital gains are typically excluded from DNI, so they are not pushed out through the distribution deduction. The trust pays the tax.
Long-term capital gains on assets held more than a year get preferential rates of 0%, 15%, or 20%. But the trust reaches the 20% top rate at the same compressed threshold as ordinary income, around $16,150 for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Add NIIT and the effective federal rate on long-term gains reaches 23.8% on nearly every dollar. Short-term gains get no preference and are taxed as ordinary income at up to 37% plus NIIT.
Gains and losses go on Schedule D of Form 1041.7Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts – Schedule D Because the brackets are so compressed, bunching multiple sales into one year amplifies the pain. Trustees should think about timing.
There are exceptions. If the trust instrument specifically allocates gains to income rather than principal, or if the trustee is required to distribute the proceeds of a sale, the gain may be included in DNI and pass through to the beneficiary. These situations require specific trust language or facts, but they can produce meaningful savings on a large sale.
Gift Tax When the Trust Is Funded
Transferring assets into a non-grantor discretionary trust is a completed gift for federal tax purposes and gets reported on Form 709.8Internal Revenue Service. About Form 709, United States Gift and Generation-Skipping Transfer Tax Return
The standard $19,000-per-recipient annual exclusion for 2026 does not help here.9Internal Revenue Service. Frequently Asked Questions on Gift Taxes Because no beneficiary has a guaranteed right to receive anything from a discretionary trust, the IRS treats the transfer as a gift of a “future interest,” which is not eligible for the annual exclusion. The full amount transferred typically counts against the settlor’s lifetime gift and estate tax exemption.
For 2026 that lifetime exemption is $15 million per individual, set by the One Big Beautiful Bill Act signed in July 2025.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The exemption will adjust for inflation starting in 2027 and, unlike the prior law under the Tax Cuts and Jobs Act, does not sunset. Cumulative lifetime gifts above the exemption face gift tax of up to 40% on the excess.
The offsetting benefit: a completed gift to a non-grantor discretionary trust removes the transferred assets, and all future growth on them, from the settlor’s taxable estate. That estate-tax result is often the whole point of setting up the trust. It only works if the settlor genuinely gives up control and beneficial interest; retained benefits pull the assets back into the estate.
Generation-Skipping Transfer Tax
When a beneficiary is two or more generations below the settlor (a grandchild, for example), distributions or terminations benefiting that person can trigger the generation-skipping transfer tax at a flat 40% rate on top of any other transfer taxes.
Each individual has a GST exemption equal to the lifetime gift and estate exemption, $15 million for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The settlor allocates it to the trust on the gift tax return at funding, which permanently shields the trust and its future growth from GST tax. Allocate it wrong, or not at all, and the 40% GST can apply later when assets reach skip-generation beneficiaries.
Trusts drafted to benefit multiple generations are typically designed to continue indefinitely, because keeping the assets inside the trust preserves the exemption. Once assets leave the trust outright, the protection is lost. A trustee who inherits an existing trust should verify GST allocation before distributing to any skip beneficiary.
State Income Taxes
Federal is not the whole picture. Most states also tax trust income, and the rules for when a state can reach a non-grantor trust vary widely. Some tax any trust created by a state resident even after it moves. Others look to the trustee’s location, the beneficiaries’ residence, or where the trust is administered. A handful have no income tax at all.
State rates on trust income reach 13% or more in the most expensive jurisdictions. Combined with 37% federal and 3.8% NIIT, the effective rate on retained trust income can pass 50%. That is another reason to distribute income out to beneficiaries in lower-tax states when the trust permits it. Because the answer turns entirely on which states connect to the trust, trustees with meaningful income should get state-specific advice.
Filing and Trustee Responsibility
Every non-grantor discretionary trust needs its own Employer Identification Number from the IRS, and that EIN appears on every tax document the trust files.10Internal Revenue Service. Employer Identification Number
Form 1041 is due April 15 for calendar-year trusts. An automatic extension is available for the return itself, but any tax owed is still due by the original date.4Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts
The trustee also has to issue a Schedule K-1 to each beneficiary who received or was allocated a distribution during the year. The K-1 tells the beneficiary exactly what to report on their own return: interest, dividends, capital gains passed through under an exception, and other income by category.11Internal Revenue Service. Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR Late or wrong K-1s block the beneficiaries from filing on time.
One item that used to worry trustees is now off the table for domestic trusts: as of March 2025, FinCEN revised its rules to exempt all domestic entities from beneficial ownership reporting under the Corporate Transparency Act. The obligation now applies only to foreign entities registered to do business in the United States.12FinCEN. Beneficial Ownership Information Frequently Asked Questions
The trustee is personally on the hook for these filings. Missed deadlines, underreported income, or missing K-1s produce penalties assessed against the trustee individually. Records that separate income from principal, track basis on every asset, and document every distribution are the minimum. Everything above (the distribution decisions, the 65-day election, the capital-gain timing, the GST allocation) works only if the paperwork behind it is clean.