Trust Income Tax Planning: The Retain vs. Distribute Decision

Not tax or legal advice. All values reflect 2026 under current law. Verify with a qualified CPA and estate attorney before acting.

A non-grantor trust reaches the 37% federal income tax bracket at just $16,000 of taxable income in 2026 — the same rate an individual doesn't reach until income above $640,600 (single filer).¹ UHNW families with multiple irrevocable trusts — SLATs, dynasty trusts, ILITs, IDGTs after the grantor's death — face this compression on income accumulated inside those trusts. The 3.8% Net Investment Income Tax adds on top of the 37% bracket starting at the same $16,000 threshold, creating a 40.8% effective federal rate on ordinary income retained in trust.

Three planning levers reduce this burden: distribution decisions (pushing income to beneficiaries in lower brackets), capital gains allocation (strategically keeping or distributing gains), and trust siting (eliminating state income tax on accumulated trust income). This guide explains each, with a calculator for the distribution decision.

Which of your trusts face income compression?

The answer turns on whether the trust is a grantor trust or a non-grantor trust.

Grantor trusts (IRC §§ 671–677) are treated as owned by the grantor for income tax purposes. All trust income — interest, dividends, rents, capital gains — flows through to the grantor's personal return and is taxed at the grantor's individual rates. No trust-level compression. Most SLATs, IDGTs, and GRATs are designed as grantor trusts. For these trusts, the grantor (often the $30M+ individual) pays the income tax, which is itself an additional tax-free gift to the trust.

Non-grantor trusts file their own Form 1041 and are taxed as a separate entity at the compressed trust rates. This is where the $16,000 problem lives. Non-grantor trusts include:

• Dynasty / generation-skipping trusts after the grantor's death (or if structured as non-grantor from inception)
• ILITs (Irrevocable Life Insurance Trusts) — by design, non-grantor to keep life insurance proceeds out of the estate
• QPRTs after the trust term ends — the trust becomes a non-grantor trust held for remainder beneficiaries
• IDGTs and SLATs after the grantor's death — grantor trust status terminates; remaining trust assets face trust-rate taxation going forward
• Testamentary trusts created under a will

2026 trust income tax brackets

Per IRS Rev. Proc. 2025-32, the 2026 ordinary income tax brackets for non-grantor trusts and estates are:

The 3.8% Net Investment Income Tax (NIIT) applies to the lesser of undistributed net investment income or the amount by which trust AGI exceeds $16,000 — the same threshold as the 37% bracket. This stacks on top: ordinary investment income above $16,000 faces 40.8% federal tax. Long-term capital gains above $16,000 face 20% + 3.8% = 23.8%.¹

The trust Alternative Minimum Tax (AMT) exemption for 2026 is $31,400, with the phaseout starting at $104,800 of trust AMT income.¹ At these low thresholds, even modest trust investment income can trigger the AMT calculation — though for most non-grantor trusts focused on LTCG and qualified dividends, the regular tax exceeds AMT so the AMT adds no additional liability.

DNI and the distribution deduction

Distributable Net Income (DNI) is the mechanism that prevents double taxation when a trust distributes income to beneficiaries. Under IRC §§ 651–663:

• The trust takes a deduction for income it distributes (up to DNI).
• The beneficiary includes the distributed DNI in their own taxable income.
• The character of the income (ordinary, dividend, capital gain) passes through to the beneficiary proportionally.

Simple trusts (IRC § 651) are required to distribute all income each year. They automatically take the DNI deduction; there is no discretion involved.

Complex trusts (IRC § 661) may accumulate income, distribute principal, or make charitable distributions. The trustee has discretion over whether to distribute ordinary income — and that discretion is the primary tax planning tool.

An important limitation: capital gains are generally excluded from DNI (IRC § 643(a)). By default, capital gains are allocated to trust corpus (principal) and are not distributed to beneficiaries as ordinary distributions. They remain in the trust and are taxed at the trust's capital gains rates. This creates different planning strategies for ordinary income vs. capital gains, as discussed below.

The retain vs. distribute decision

The core logic: distributing ordinary trust income to a beneficiary in a lower bracket saves tax. When the beneficiary is in the same top bracket as the trust, distribution has no tax advantage.

Worked example:

• Dynasty trust earns $80,000 in ordinary income (interest, rents) in 2026.
• Beneficiary is a 32-year-old child with $120,000 of W-2 income — in the 22% bracket after standard deduction.

If the trust retains all $80,000:

• First $3,300 × 10% = $330
• $3,301–$11,700 × 24% = $2,016
• $11,701–$16,000 × 35% = $1,505
• $16,001–$80,000 × 37% = $23,680
• NIIT: ($80,000 − $16,000) × 3.8% = $2,432
• Total trust tax: $29,963 (37.5% effective rate)

If the trust distributes the full $80,000 to the beneficiary:

• Trust deduction for $80,000 distributed → trust pays $0 income tax
• Beneficiary's marginal rate on the additional $80,000 is 22% (assuming no bracket jump): $80,000 × 22% = $17,600
• Total tax: $17,600 (22% effective rate)
• Annual savings: $12,363

Over 20 years, the compounding effect of saving $12,000+/year in taxes — while also building the beneficiary's savings — is significant. The trust may also wish to make partial distributions, optimizing the beneficiary's bracket use without pushing them into a higher bracket.

Interactive: Retain vs. Distribute Calculator

Estimate the federal income tax impact of retaining vs. distributing ordinary trust income. Does not include state income tax or NIIT on capital gains.

Capital gains: the exception

Capital gains receive different treatment than ordinary income in trusts — and understanding this difference opens a separate set of planning options.

By default, capital gains stay in the trust. Under IRC § 643(a), capital gains allocated to trust corpus are excluded from DNI. The trust pays capital gains tax on them, and they are not distributed to beneficiaries through the normal distribution mechanism. The 2026 trust LTCG rates are:

For a trust with $500,000 of LTCG, virtually all of it falls above $16,000 and faces 23.8% — the same rate an individual in the top bracket pays. There is no advantage to retaining gains in a trust vs. recognizing them at the individual level for a UHNW investor already in the top LTCG bracket.

The exception: capital gains can be included in DNI if (a) the trust document or applicable state law allocates gains to income, or (b) the trustee has a consistent practice of allocating capital gains to distributable income and exercises that discretion in a consistent, non-arbitrary manner (Reg § 1.643(a)-3). If capital gains are included in DNI, they can be distributed to beneficiaries and retain their long-term capital gains character — which can be advantageous if the beneficiary is in the 0% or 15% LTCG bracket.

In-kind distributions: A trustee can distribute appreciated assets in-kind to beneficiaries rather than cash. Under IRC § 643(e), the default rule is that in-kind distributions carry out DNI equal to the lesser of the property's basis or its fair market value. The beneficiary takes the trust's basis, and the gain is deferred until the beneficiary sells. For appreciated trust assets, this can shift capital gains recognition from the trust to a lower-bracket beneficiary — and if the beneficiary holds the asset until death, the § 1014 step-up could eliminate the gain entirely.

State income tax on trust income

Federal brackets tell only part of the story. Several states impose their own income tax on trust income, which can add 5%–13% to the effective rate. The rules vary by state and depend on where the trust was created, where the trustee resides, and where the beneficiaries live.

Zero-income-tax jurisdictions for trust siting: South Dakota, Nevada, Florida, Wyoming, and Texas impose no state income tax on accumulated trust income held in properly structured trusts with in-state trustees.⁴ A UHNW family in California can establish a South Dakota dynasty trust with a South Dakota corporate trustee, and income accumulated in the trust is not subject to California income tax — as long as the income does not derive from California-source activities and the trust has no California trustees.

California's reach: California's Franchise Tax Board has an aggressive position on trust taxation. It claims income tax jurisdiction if (a) a trustee is a California resident, (b) a beneficiary is a California resident, or (c) the trust derives California-source income. Even a South Dakota trust with a CA-resident beneficiary may owe California tax on distributions to that beneficiary. The California non-resident beneficiary exemption is available only if no part of the distribution is attributable to California-source income.

New York NING trusts: New York residents sometimes use a "New York Incomplete Gift Non-Grantor Trust" (NY NING) — an incomplete gift trust that is not a grantor trust, designed to accumulate income free from New York state income tax. These structures are complex and require careful attention to IRS guidance and NY Dept. of Taxation positions.

The state income tax on trust income is often the largest planning gap for UHNW families, because it is highly jurisdiction-specific and varies based on which trusts were created before vs. after moving to a high-tax state. A fee-only advisor coordinating with an estate attorney in the trust's siting jurisdiction can often reduce this exposure substantially.

Trust AMT

Non-grantor trusts are subject to the Alternative Minimum Tax under IRC § 55. The 2026 trust AMT exemption is $31,400, with the phaseout beginning at $104,800 of trust alternative minimum taxable income (AMTI).¹ The AMTI phaseout rate is 25%, so the exemption is fully phased out by $230,400 of AMTI.

In practice, most non-grantor trusts holding traditional investment portfolios (qualified dividends, LTCG, municipal bonds) do not generate significant AMT preference items. Private activity bonds are an exception — PAB interest, while excluded from regular income, is an AMT preference item. UHNW families heavily invested in muni bonds should confirm whether any bonds are private activity bonds before holding them in a non-grantor trust.

§199A QBI deduction in trusts

Non-grantor trusts that hold interests in qualifying pass-through businesses — S-corporations, partnerships, sole proprietorships — may claim the §199A qualified business income (QBI) deduction, which was made permanent by the One Big Beautiful Bill Act (OBBBA, July 2025). The deduction can reduce taxable income by up to 20% of QBI from eligible businesses.

The §199A SSTB (specified service trade or business) limitation and the W-2 wages / UBIA of qualified property limitation apply to trusts using the trust's taxable income as the phase-in base. Because trust taxable income compresses so rapidly to the top bracket, the SSTB limitation phases in much faster for trusts than for individual taxpayers. Work with a CPA on the trust-specific §199A calculation before relying on the deduction for trust tax planning.⁵

Working with a UHNW advisor on trust income tax planning

Trust income tax planning requires coordination across three professionals:

• CPA (or trust tax specialist) for Form 1041, DNI calculations, §199A computation, state income tax exposure, and the distribute vs. retain analysis for each trust each year.
• Estate attorney to review trust documents for distribution standard language, trustee discretion provisions, and capital gains allocation provisions — and to amend documents where flexibility is lacking.
• Fee-only financial advisor to integrate the distribution strategy with overall family income planning: coordinating which trust distributes when to optimize across family members' tax brackets, timing in low-income years, and connecting trust income planning to the estate plan.

For a family with five non-grantor trusts generating $400,000 in aggregate ordinary income, the gap between the worst-case outcome (all retained at 40.8%) and the best-case outcome (distributed to lower-bracket beneficiaries and sited in zero-tax jurisdictions) can exceed $100,000 per year in tax. That planning gap compounds every year and becomes a seven-figure difference over a dynasty trust's lifetime.

Sources

1. IRS Rev. Proc. 2025-32 — 2026 inflation adjustments for estates and trusts: ordinary income brackets (10%/$3,300, 24%/$11,700, 35%/$16,000, 37%/over $16,000); NIIT trust threshold $16,000; AMT exemption $31,400 (phaseout $104,800); individual 37% bracket single $640,600. Verified May 2026.
2. IRC § 643 — Definition of Distributable Net Income (DNI): the calculation base that limits the trust distribution deduction and characterizes income flowing to beneficiaries. Capital gains excluded from DNI by default under § 643(a)(3).
3. Treas. Reg. § 1.643(a)-3 — Capital gains included in DNI exception: when a trustee may allocate capital gains to distributable income through consistent practice or trust document authority, allowing capital gains to retain their character and pass to beneficiaries.
4. South Dakota Trust Code (Title 55) — No Rule Against Perpetuities, no state income tax on trust income for trusts with SD trustee and no SD-source income, directed trust statute, strong spendthrift protections. Primary jurisdiction for UHNW dynasty trust and SLAT siting.
5. IRS — § 199A Qualified Business Income Deduction: applies to trusts and estates; OBBBA (July 2025) made the deduction permanent. Trust-level § 199A calculation uses trust taxable income as the threshold base.

Trust income tax rules are complex and jurisdiction-specific. All federal values reflect 2026 under current law (post-OBBBA, post-SECURE 2.0) per Rev. Proc. 2025-32. State income tax rules vary significantly. Verify with a qualified CPA and estate attorney before making distribution or trust-siting decisions.