Testamentary Trust Taxation: Brackets, Distributions, and Filing

A testamentary trust — one created by a will and funded after the grantor dies — is treated as its own taxpayer, and the taxation of a testamentary trust turns on a single hard fact: the trust hits the top 37% federal bracket at just $16,000 of taxable income for 2026.¹ Income distributed to beneficiaries is taxed on their personal returns instead, almost always at a lower rate. Everything else about trust tax planning follows from that gap.

The Trust’s Own Brackets Are Brutal

Once a testamentary trust holds income-producing assets, the IRS taxes it separately from the beneficiaries. For 2026, the trust brackets are:

10% on taxable income up to $3,300
24% from $3,301 to $11,700
35% from $11,701 to $16,000
37% above $16,000

An individual filer doesn’t reach 37% until taxable income exceeds roughly $609,000. A trust gets there at $16,000.¹ A trust sitting on $50,000 of undistributed ordinary income owes well over $15,000 in federal tax. The same $50,000 in the hands of a beneficiary in the 22% bracket generates about $11,000. That difference repeats every year the trustee doesn’t plan around it.

The personal exemption barely helps. A trust required to distribute all income currently gets a $300 exemption. Every other trust gets $100.²

How Distributions Move the Tax

The mechanism that shifts income out of the trust and onto beneficiaries is Distributable Net Income, or DNI. DNI is the trust’s taxable income with several adjustments: capital gains allocated to corpus are excluded, the distribution deduction is backed out, the personal exemption is removed, and tax-exempt interest is added back in.³

DNI works as both ceiling and floor. It caps the deduction the trust can claim for distributions, and it caps the amount beneficiaries must report as income. Distribute more than DNI, and the excess is a tax-free return of principal. Distribute less, and the trust pays tax at compressed rates on what stays behind.

Character carries through the distribution. Qualified dividends distributed to a beneficiary remain qualified dividends on the K-1 and on the beneficiary’s Form 1040. Tax-exempt municipal bond interest passes through as tax-exempt. This matters because the preferential rates on qualified dividends and long-term capital gains only apply if the income keeps its character on the way out.

Simple vs. Complex Trusts

A simple trust must distribute all of its income every year, cannot touch principal for distributions, and makes no charitable contributions.⁴ Because income flows out automatically, the distribution deduction equals DNI and the trust itself usually owes no income tax. The beneficiary picks up the full bill.

Any trust that fails one of those three conditions is a complex trust. It can accumulate income, distribute principal, or make charitable gifts. The trustee has discretion, which is exactly where the planning problem lives: income kept inside gets hit at trust rates, income sent out gets taxed to beneficiaries at theirs.

The 65-Day Rule

A trustee often doesn’t know the trust’s final income figures until well into the next year. The 65-day rule handles that timing mismatch. Under this election, a trustee of a complex trust can distribute cash within the first 65 days of a new tax year and treat it as paid on the last day of the prior year.⁵

Say a mutual fund inside the trust throws off a large capital gain distribution in December. Without the election, that income is stuck at the trust and taxed at 37%. Distribute the cash in January or February, make the election on the prior year’s Form 1041, and the income shifts to the beneficiaries at their lower rates.

The amount treated as distributed in the prior year cannot exceed the trust’s income or DNI for that year, whichever is greater, reduced by amounts already distributed during the year.⁵ Simple trusts and grantor trusts can’t use it.

The 3.8% Net Investment Income Tax

On top of the regular income tax, IRC 1411 imposes a 3.8% surtax on net investment income. For individuals, the surtax only applies once AGI exceeds $200,000 (or $250,000 filing jointly). For a trust, it kicks in once AGI exceeds the threshold for the top income tax bracket, which for 2026 is $16,000.⁶

Net investment income includes interest, dividends, annuities, royalties, rents, and capital gains. The surtax applies to the lesser of the trust’s undistributed net investment income or the amount its AGI exceeds $16,000.⁶ The trustee reports it on Form 8960.⁷

Distributing investment income out of the trust also gets it out of the NIIT calculation at the trust level. The beneficiary may still owe the surtax personally, but only if their own AGI clears the much higher individual threshold. For most beneficiaries, the distribution eliminates it.

Capital Gains and Stepped-Up Basis

Assets funding a testamentary trust receive a stepped-up basis equal to fair market value on the date the grantor died.⁸ Gains that built up during the decedent’s lifetime disappear for tax purposes. Stock bought for $10,000 and worth $100,000 at death carries a $100,000 basis into the trust; selling it the next day at that price produces no taxable gain.

Gains from later sales are a different matter. Capital gains are generally excluded from DNI and taxed at the trust level, because the statute keeps gains allocated to corpus out of the DNI calculation unless they are distributed or set aside for charity.³ The trust gets the same 0%, 15%, and 20% long-term rates individuals do, but the income thresholds where those rates step up are far lower.

If the trust instrument or local law directs that capital gains be distributed to beneficiaries, the gains flow into DNI and pass through on the K-1. Drafting matters here: a trust that gives the trustee discretion to allocate gains between income and corpus creates real flexibility.

What the Beneficiary Reports

Each beneficiary receives a Schedule K-1 as part of the trust’s annual Form 1041 filing.⁹ The K-1 breaks the distribution into categories — ordinary income, qualified dividends, tax-exempt interest, capital gains — and the beneficiary carries each line to the matching spot on Form 1040.¹⁰

Distributions of principal are not taxable income. If the trustee distributes $30,000 and DNI is only $10,000, the beneficiary reports $10,000 and receives the other $20,000 tax-free. The trustee needs to document the split, because the beneficiary has no independent way to figure it out.

When the trust terminates, unused deductions, capital loss carryovers, and net operating loss carryovers pass through on the final K-1 in Box 11 and keep their character. Section 67(e) expenses unique to trust administration remain deductible in arriving at adjusted gross income.¹¹ Beneficiaries should look for those items on the final K-1; missing them leaves valid deductions on the table.

Filing the Trust’s Return

Before anything else, the trust needs its own Employer Identification Number. The trustee applies on Form SS-4, and the online application returns an EIN immediately.¹²

Trusts are required by federal law to use a calendar year; only trusts exempt from tax and certain charitable trusts can use anything else.¹³ The first tax year may be a short period from the funding date through December 31.

Form 1041 reports income, claims the distribution deduction, and calculates any tax owed, with a K-1 issued to each beneficiary.⁹ The deadline is April 15 of the following year.¹⁴ Form 7004 gets an automatic extension if filed by the original due date.¹⁵

A trust expecting to owe $1,000 or more after withholding and credits must make quarterly estimated payments on Form 1041-ES. For 2026, the installments fall on April 15, 2026, June 15, 2026, September 15, 2026, and January 15, 2027. Underpaying triggers a penalty even if most of the income eventually gets distributed, because the estimated obligation is based on projected liability, not the year-end result.¹

State Fiduciary Tax

Federal tax is only part of the answer. Most states with an income tax also tax trusts, and the residency rules vary. Common factors include where the decedent lived at death, where the trustee is located, where the beneficiaries reside, and where the trust is administered. A trust classified as resident in a state is generally taxed on all of its income; a nonresident trust is typically taxed only on income sourced within that state. When one state taxes as a resident and another taxes at source, many states offer a credit to prevent double taxation. Any testamentary trust with connections in more than one state needs a return-by-return look at where it may owe.

1
Internal Revenue Service. Form 1041-ES – Estimated Income Tax for Estates and Trusts
2
Office of the Law Revision Counsel. 26 US Code 642 – Special Rules for Credits and Deductions
3
Office of the Law Revision Counsel. 26 US Code 643 – Definitions Applicable to Subparts A, B, C
4
eCFR. 26 CFR 1.651(a)-1 – Simple Trusts; Deduction for Distributions; In General
5
eCFR. 26 CFR 1.663(b)-1 – Distributions in First 65 Days of Taxable Year
6
Office of the Law Revision Counsel. 26 US Code 1411 – Imposition of Tax
7
Internal Revenue Service. Instructions for Form 8960
8
Office of the Law Revision Counsel. 26 US Code 1014 – Basis of Property Acquired From a Decedent
9
Internal Revenue Service. About Form 1041, US Income Tax Return for Estates and Trusts
10
Internal Revenue Service. Schedule K-1 (Form 1041) – Beneficiary’s Share of Income, Deductions, Credits, etc.
11
Internal Revenue Service. Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR
12
Internal Revenue Service. Instructions for Form SS-4
13
Office of the Law Revision Counsel. 26 USC 644 – Taxable Year of Trusts
14
Internal Revenue Service. Forms 1041 and 1041-A – When to File
15
Internal Revenue Service. About Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns