A discretionary trust tax bill depends almost entirely on one choice the trustee makes each year: distribute the income or keep it inside the trust. A non-grantor discretionary trust that retains its income faces the most compressed rate schedule in the federal code, hitting the top 37% rate once taxable income crosses roughly $16,150 for 2026. A single individual filer doesn’t reach that bracket until income exceeds $626,350.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Distributing income shifts the tax to the beneficiary’s lower personal rate. Nearly every tax decision a trustee makes comes back to that gap.
Grantor Trust or Non-Grantor Trust
Before any of the rate math matters, confirm which kind of discretionary trust you have. If the person who created the trust kept the power to revoke it, swap assets, control who benefits from income, or kept a reversionary interest, the IRS treats it as a grantor trust. The trust is invisible for income tax purposes. Every dollar of income, every gain, every deduction flows to the grantor’s personal return, and the compressed trust brackets never apply.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. The trust is its own taxpayer with its own EIN, files its own return, and faces the compressed brackets. Everything that follows assumes a non-grantor trust, because that is where the tax complexity lives.
What Retained Income Costs
When the trust earns income and the trustee doesn’t distribute it, the trust pays federal tax on what it keeps. Ordinary income runs up through the brackets fast, hitting 37% above roughly $16,150 for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
On top of that, undistributed net investment income is subject to the 3.8% Net Investment Income Tax. The surtax applies once the trust’s adjusted gross income crosses the threshold where the top ordinary bracket begins.3Internal Revenue Service. Topic No. 559, Net Investment Income Tax Combined, the federal rate on retained investment income can exceed 40% before any state tax.
Concretely: a trust that accumulates $50,000 in interest during 2026 pays the 37% rate on nearly all of it, plus the 3.8% NIIT on the undistributed portion. Federal tax alone comes to roughly $20,000. That math is what drives most trustees to distribute.
The trust reports everything on IRS 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 Income not distributed by year-end (or inside the 65-day window below) stays on that return at trust rates.
How Distributions Move the Tax to the Beneficiary
Distributing income is the main tool for avoiding the trust’s compressed rates. When the trustee distributes during the year, the trust takes a deduction for the amount distributed, and the beneficiary picks up the income on their personal return. The income is taxed once, at the beneficiary’s marginal rate.
The ceiling on how much of a distribution carries income is set by Distributable Net Income, or DNI. DNI is essentially the trust’s net taxable income for the year, with 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 beyond DNI is treated as principal and isn’t taxable to the beneficiary.
Income keeps its character on the way out. If the trust earned $30,000 in qualified dividends and $10,000 in interest and distributed the full $40,000, the beneficiary reports $30,000 as qualified dividends (preferential rates) and $10,000 as ordinary interest. The trust sends a Schedule K-1 (Form 1041) spelling out each category.6Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts – Schedule K-1
The practical impact: if the trust retains that $40,000, federal tax runs about $15,800 (37% on nearly the full amount, plus NIIT). Distribute the same $40,000 to a beneficiary in the 12% bracket, and their federal tax on the same income is around $4,800. The savings are large and recurring, which is why distribution policy is the single most important tax lever a trustee controls.
Distributions of principal, meaning the original assets plus income already taxed to the trust in prior years, generally aren’t taxable to the beneficiary. The trustee has to track and distinguish income from principal carefully when preparing each K-1. Getting that line wrong creates reporting problems that follow every beneficiary into their own return.
The 65-Day Election
Trustees rarely know the trust’s full income picture on December 31. A distribution in January or February often makes more sense once the numbers settle. Federal tax law allows a Section 663(b) election: the trustee can treat distributions made within the first 65 days of the new tax year as if made on the last day of the prior tax year.
The election is made on the trust’s Form 1041 for the prior year. It pulls the distribution deduction back into that return and shifts the income to the beneficiary for the same year. It is particularly useful when income spiked late in the year and there wasn’t time to distribute before December 31. The election doesn’t change who ultimately pays. It just gives the trustee time to make the call with real numbers. Trustees who forget it exists sometimes hand over thousands in trust-level tax that a timely January distribution would have erased.
Capital Gains Usually Stay With the Trust
When the trust sells an appreciated asset, the gain is generally taxed to the trust rather than pushed out to beneficiaries. Capital gains are typically excluded from DNI, so they don’t flow through the distribution deduction.
Long-term gains on assets held more than a year get preferential rates of 0%, 15%, or 20%. The trust reaches the top 20% rate at roughly the same compressed threshold (around $16,150 for 2026), where an individual wouldn’t hit it until income exceeded about $518,900.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Add the 3.8% NIIT and the effective federal rate on long-term gains inside the trust reaches 23.8% on nearly every dollar.
Short-term gains get no break. They’re taxed as ordinary income at the compressed brackets, which can mean 37% plus NIIT.
Gains and losses are reported on Schedule D of Form 1041.7Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts – Schedule D Bunching multiple sales into one year amplifies the pain of the compressed brackets, so trustees should think about timing before executing large sales.
There are exceptions. If the trust instrument allocates gains to income rather than principal, or if the trustee is required to distribute sale proceeds, gains can be included in DNI and passed through to the beneficiary. These depend on specific trust language and circumstances, but they can produce meaningful savings when a large gain is on the table.
State Income Tax Compounds the Federal Bill
Federal is only part of the picture. Most states tax trust income, and the rules for when a state can tax a non-grantor trust vary widely. Some states tax any trust created by a resident. Others look at where the trustee sits, where beneficiaries live, or where the trust is administered. A handful have no income tax at all.
State rates on trusts reach 13% or higher in the most expensive jurisdictions. Combined with 37% federal and 3.8% NIIT, the total effective rate on retained trust income can exceed 50%. That gap is another reason to distribute to beneficiaries in lower-tax states when the trust terms permit. The specifics depend on which states have a connection to the trust, so trustees with meaningful income should get state-specific advice.
Gift Tax When Funding the Trust
Transferring assets into a non-grantor discretionary trust is a gift for federal tax purposes, reported on IRS Form 709.8Internal Revenue Service. About Form 709, United States Gift and Generation-Skipping Transfer Tax Return
The annual gift exclusion is $19,000 per recipient for 2026, but discretionary trusts hit a snag: because no beneficiary has a guaranteed right to anything, the IRS treats the transfer as a gift of a “future interest.”9Internal Revenue Service. Frequently Asked Questions on Gift Taxes Future interest gifts don’t qualify for the annual exclusion. The full amount 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. The exemption adjusts for inflation starting in 2027, and unlike the prior Tax Cuts and Jobs Act figure, there is no sunset.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 If lifetime gifts exceed the exemption, gift tax of up to 40% applies on the excess.
The upside: a completed gift to the trust removes the assets from the settlor’s taxable estate. Fund the trust with $5 million that grows to $15 million by the time the settlor dies, and the full $15 million sits outside the estate. That is often the main reason for creating the trust. The result depends on the settlor truly giving up control and beneficial interest; retain the right to benefit, and the IRS pulls the assets back into the estate.
Generation-Skipping Transfer Tax
If any beneficiary is two or more generations below the settlor, such as a grandchild, distributions to that beneficiary or terminations in their favor can trigger the generation-skipping transfer tax. The GST rate is a flat 40% on top of other transfer taxes.
Each individual has a GST exemption that mirrors the lifetime gift and estate exemption: $15 million for 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The settlor can allocate exemption to the trust when it is funded, shielding future distributions and growth. The allocation has to be made correctly on the gift tax return. If the settlor fails to allocate, or if the trust later terminates and distributes outright to skip-generation beneficiaries, the 40% GST tax can hit the full value at that point.
Trusts drafted to benefit multiple generations (sometimes called dynasty trusts) are typically written to continue indefinitely, because once assets leave the trust the exemption protection is gone. Trustees of a trust with skip-generation beneficiaries should confirm the GST exemption was properly allocated before making distributions.
Filing Requirements the Trustee Owns
Every non-grantor discretionary trust needs its own Employer Identification Number from the IRS. The EIN goes 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, but any tax owed is still due by the original deadline.4Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts
The trustee also has to send a Schedule K-1 to every beneficiary who received or was allocated a distribution during the year. The K-1 tells the beneficiary exactly what to report: how much interest, dividends, capital gain, and other income their distribution carried.11Internal Revenue Service. Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR Late or inaccurate K-1s cascade: beneficiaries can’t finish their own returns without them.
The trustee is personally on the hook for all of it. Missed deadlines, underreported income, or missing K-1s can produce penalties assessed against the trustee individually. Clean records that distinguish income from principal, track the basis of every asset, and document every distribution are the baseline for competent administration.