The tax on an investment bond in trust turns on one question before any other: is the trust a grantor trust or a non-grantor trust? A grantor trust is ignored for income tax purposes, so all gains flow to the grantor’s Form 1040 and are taxed at individual rates. A non-grantor trust is its own taxpayer, files Form 1041, and either pays tax at compressed brackets that reach 37% at just $16,000 of taxable income in 2026, or passes the income out to beneficiaries who report it on their own returns. In the United States, “investment bonds” held in trust typically mean non-qualified deferred annuities or cash-value life insurance policies, and each carries additional rules that can quietly undo the tax deferral people bought the product to get.
Grantor Trust or Non-Grantor Trust
A grantor trust exists when the person who created it keeps certain powers or interests over the trust assets. The IRS treats the trust as if it doesn’t exist for income tax purposes. Gains, losses, and deductions flow directly to the grantor, who reports them on Form 1040 at individual rates.1Office of the Law Revision Counsel. 26 U.S. Code Subchapter J Part I Subpart E – Grantors and Others Treated as Substantial Owners Most revocable living trusts are grantor trusts, and many irrevocable trusts are intentionally drafted to keep grantor status, often by having the grantor retain the power to substitute assets of equal value. A separate trust return is generally optional; the income shows up on the grantor’s personal return.2Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts
A non-grantor trust is a separate taxpayer. The trustee files Form 1041 and works with a concept called Distributable Net Income to decide how the tax burden gets split. Income the trust distributes generates a deduction for the trust and lands on the beneficiary’s Schedule K-1; income the trust retains is taxed inside the trust at the compressed rates below.2Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts Because those retained-income rates are so steep, distribution decisions are the most consequential tax choices a trustee makes each year.
The Non-Natural Person Rule
Before worrying about brackets, a trustee holding a non-qualified annuity has to confirm the contract still qualifies for tax deferral at all. Section 72 strips tax-deferred treatment from any annuity held by a “non-natural person,” which includes trusts. Without an exception, the trust would owe tax annually on the contract’s internal gains and lose the reason for using an annuity in the first place.3Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The exception applies when the trust holds the annuity “as an agent for a natural person.” The legislative history clarifies that if the beneficial owners are actual human beneficiaries, the trust is treated as a nominal owner and the contract keeps deferral. Trusts with identifiable individual beneficiaries usually clear the bar; trusts with charitable beneficiaries or vague beneficiary classes can fail it. Confirm this before transferring an annuity into any trust, because getting it wrong forfeits deferral entirely.3Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2026 Trust Brackets and the Net Investment Income Tax
While gains stay inside the contract, no annual income tax is owed. Internal growth remains deferred until someone takes a distribution or surrenders the contract. Once money comes out, or if the trust earns other investment income, the compressed brackets hit fast. For 2026, non-grantor trusts pay federal income tax on the following schedule:4Internal Revenue Service. Rev. Proc. 2025-32
- 10% on taxable income up to $3,300
- 24% on taxable income from $3,301 to $11,700
- 35% on taxable income from $11,701 to $16,000
- 37% on taxable income over $16,000
On top of that, non-grantor trusts owe the 3.8% Net Investment Income Tax on undistributed investment income once adjusted gross income exceeds $16,000, the same point the top ordinary bracket kicks in. A trust that holds investment income inside itself can face an effective federal rate above 40% on amounts over that threshold. A grantor trust sidesteps this problem because everything flows to the grantor, where the NIIT doesn’t apply until modified AGI exceeds $200,000 single or $250,000 married filing jointly.5Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Trustees must also make estimated payments on Form 1041-ES if the trust will owe $1,000 or more after withholding and credits. This gets missed most often in the year a bond is surrendered, because the lump of income can dwarf anything the trust reported before.
How Withdrawals and Surrenders Are Taxed
Money coming out of a non-qualified annuity — through a partial withdrawal or a full surrender — comes out earnings first. Any amount received before annuitization is treated as gain until gains are exhausted, and only then as a return of the premiums you paid in. You cannot pull just principal to avoid tax.6Office of the Law Revision Counsel. 26 USC 72
The taxable portion is ordinary income, not capital gains. Where that tax lands depends on trust type. In a grantor trust, the gain hits the grantor’s Form 1040 at their marginal rate. In a non-grantor trust, the trustee decides whether to distribute the income to beneficiaries, who then pay at their own rates, or hold it inside the trust and face the compressed brackets. Distributing income to beneficiaries in lower brackets is usually the cleanest way to reduce the total tax bill, if the trust instrument permits it.
Withdrawals taken before the annuitant reaches age 59½ trigger an additional 10% penalty on the taxable portion. That penalty applies to trust-owned contracts too. Exceptions exist for distributions after the death of the contract holder, distributions due to disability, and a series of substantially equal periodic payments over the annuitant’s life expectancy.3Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
No Step-Up in Basis at Death
This is where annuities diverge sharply from other trust assets. Stocks, real estate, and mutual funds held in trust generally receive a stepped-up basis at the owner’s death, wiping out unrealized gains. Non-qualified annuities do not. Section 1014 excludes them, and any deferred gain inside the contract becomes income in respect of a decedent that the trust or its beneficiaries will eventually owe tax on.7Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
A beneficiary inheriting a trust-owned annuity with $200,000 in deferred gains will owe ordinary income tax on every dollar of those gains as distributions come out. Families who assume the step-up applies to everything in the trust often get an unpleasant surprise.
Section 1035 Exchanges
A trustee stuck with a high-fee or poorly performing annuity does not have to surrender it and take the tax hit. Section 1035 allows tax-free exchanges between certain insurance products, and a trustee can use it to swap one annuity for another, or a life insurance policy for an annuity, without recognizing gain.8Office of the Law Revision Counsel. 26 USC 1035
The allowed exchanges run one direction along a hierarchy. Life insurance can be exchanged for life insurance, an endowment, or an annuity. An endowment can be exchanged for another endowment with the same or earlier start date, or for an annuity. An annuity can only be exchanged for another annuity; an annuity cannot be exchanged for life insurance.
The exchange must happen directly between the insurance companies. If the trustee receives a check and then buys a new contract, the transaction fails and the entire gain becomes taxable. The owner and annuitant on the new contract must match the old one, and consolidations of multiple contracts require the same owner and insured across all of them.
The Modified Endowment Contract Trap
Cash-value life insurance held in trust has one clear tax edge over an annuity: withdrawals and loans can generally reach cash value on a principal-first basis, with no tax on amounts up to total premiums paid. But if the policy is overfunded — too much premium relative to the death benefit — it fails the 7-pay test and becomes a modified endowment contract (MEC).9Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
Once a policy becomes a MEC, it loses that favorable withdrawal treatment and gets taxed like an annuity. Earnings come out first as ordinary income, withdrawals before age 59½ face the 10% penalty, and policy loans are treated as distributions for tax purposes. The 7-pay test compares cumulative premiums during the first seven contract years to the net level premiums that would fund the death benefit over that period. If cumulative payments exceed that threshold at any point, the contract is permanently a MEC. Replacing it through a Section 1035 exchange carries the MEC status to the new contract.
Watch the threshold closely when funding a new policy through a trust. The urge to make large upfront contributions to build cash value quickly is exactly what triggers MEC classification.
Gift Tax on Contributions to the Trust
Every transfer of cash or property into an irrevocable trust is a taxable gift. When you contribute premiums so the trustee can pay for a policy or fund an annuity, you are gifting to the trust beneficiaries, and reportable gifts must go on Form 709 for the year they are made.10Internal Revenue Service. Instructions for Form 709
The 2026 annual gift tax exclusion is $19,000 per recipient. Gifts to a trust don’t automatically qualify, because beneficiaries have no immediate right to use the money. Most irrevocable trusts solve this with Crummey powers: temporary withdrawal rights, typically 30 days, that let each beneficiary pull out their share of a contribution. Beneficiaries rarely exercise the right, but its existence converts the gift from a non-excludable future interest to an excludable present interest.11Internal Revenue Service. Whats New – Estate and Gift Tax
Contributions above the annual exclusion multiplied by the number of beneficiaries eat into the grantor’s lifetime gift and estate tax exemption. A trust with four beneficiaries allows up to $76,000 in annual contributions ($19,000 × 4) before that happens. The trustee must send written Crummey notices to every beneficiary for each contribution; skipping the notices can disqualify the annual exclusion for that year’s gifts.
The Practical Takeaway
Trust type drives the tax outcome more than the bond itself does. If the trust is a grantor trust, taxation looks much like personal ownership at the grantor’s rates. If the trust is a non-grantor trust, the compressed brackets and the 3.8% NIIT threshold at $16,000 make retained income expensive, and the trustee’s real work is deciding what to distribute and when. On top of that, keep the non-natural person rule satisfied, watch the 7-pay line on any life policy, remember that no step-up will bail out deferred annuity gains at death, and use Section 1035 rather than a surrender whenever you need to reposition.