A trust makes money by holding assets that generate income or gain value, and it pays beneficiaries either on a schedule the trust document requires or at the trustee’s discretion, with the tax bill landing on whoever ends up with the cash. That is the short version of how a trust makes money and pays beneficiaries. The longer version turns on three things: what sits inside the trust, what the trust instrument tells the trustee to do with the earnings, and how the federal tax code treats what gets distributed versus what stays put.
Where the Money Comes From
A trust earns income the same way any investor does. Residential and commercial real estate produce rent, usually the most predictable cash flow because lease payments arrive on a schedule. Shares in publicly traded companies produce dividends. Corporate and municipal bonds pay interest at fixed intervals, and municipal bond interest is often tax-exempt. Diversified index funds combine dividends with long-term growth.
Business interests show up more often than people expect. A grantor who owns shares in a closely held company or membership interests in an LLC can transfer those into the trust, and the trust then participates in business profits through distributions. These holdings can be lucrative but illiquid, which creates a problem when a beneficiary needs cash and the only asset throwing off real value is a minority stake in a private company.
Some trusts now hold digital assets. Cryptocurrency staking rewards count as ordinary income at their fair market value when the trust gains control over them, under Revenue Ruling 2023-14, whether the tokens are sold or held.1Internal Revenue Service. Revenue Ruling 2023-14
Income Versus Principal
Trust wealth grows through two separate channels, and the trust document and tax code treat them differently. The first is income: interest, dividends, rent, and business distributions arriving as cash. The second is appreciation: the rise in an asset’s market value, which only becomes a realized gain when the trustee sells.
If the trustee bought a property for $100,000 and later sells it for $150,000, the $50,000 profit is a capital gain. That gain gets added to principal rather than being classified as income, unless the trust document or state law says otherwise. This matters because many trusts have one set of beneficiaries entitled to income during their lifetime and a separate set who receive the principal when the trust eventually terminates. Capital gains typically stay with the principal beneficiaries. Dividends and interest flow to the income beneficiaries.
Reinvestment is where compounding happens. When a trustee takes dividend income or bond interest and buys additional shares instead of distributing every dollar, the asset base grows. Over a long horizon, reinvested earnings can dwarf the original contribution, which is why grantors who set up multi-generational trusts often give the trustee broad authority to reinvest rather than distribute everything as it comes in.
How Beneficiaries Actually Get Paid
Whether a beneficiary receives money, and when, depends on what the trust document requires.
Mandatory distribution trusts require the trustee to pay out all income, a fixed dollar amount, or a set percentage of assets on a defined schedule. The trustee has no choice. If the trust says “distribute all net income quarterly to my spouse,” the income goes out every quarter regardless of what markets are doing.
Discretionary trusts give the trustee authority to decide how much and when. Many trust documents limit that discretion with a standard tied to the beneficiary’s health, education, maintenance, and support (often shortened to HEMS). The standard gives the trustee room to respond to changing circumstances while preventing distributions that would drain the trust for no good reason. A beneficiary asking for $50,000 to buy a boat will have a harder time than one asking for $50,000 for surgery.
The trust document also controls the timing. Some trusts pay out quarterly, some annually, some only on specific triggers like a beneficiary reaching a certain age or finishing school. A trustee who distributes outside what the document allows can face personal liability; a trustee who refuses to distribute what the document requires can be sued by the beneficiary.
Who Pays the Tax
The tax treatment of trust earnings is the single biggest factor in how much actually survives to benefit anyone, and it turns on whether the trust is a grantor trust or a non-grantor trust.
Grantor Trusts
If the grantor retained certain powers over the trust, the IRS ignores the trust as a separate taxpayer. All income, deductions, and credits flow through to the grantor’s personal return as though the trust doesn’t exist.2Office of the Law Revision Counsel. 26 USC 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners For wealthy families this is a feature, not a bug: the grantor absorbs the tax bill, and the trust’s assets compound without being reduced by taxes.
Non-Grantor Trusts and the Compressed Brackets
When the grantor hasn’t retained enough control, the trust is its own taxpayer and files Form 1041 if it has gross income of $600 or more for the year.3Internal Revenue Service. 2025 Instructions for Form 1041 and Schedules A, B, G, J, and K-1 This is where the math gets painful. For 2026, the trust tax brackets are compressed into an absurdly narrow range:4Internal Revenue Service. Revenue Procedure 2025-32
- 10% on taxable income up to $3,300
- 24% on income from $3,300 to $11,700
- 35% on income from $11,700 to $16,000
- 37% on income over $16,000
An individual doesn’t hit the 37% bracket until income exceeds roughly $626,000. A trust gets there at $16,000. That single fact drives most of what trustees do at year-end.
The Distribution Deduction
The escape valve is the distribution deduction. When a non-grantor trust distributes income to beneficiaries, the trust deducts those distributions and the beneficiaries report the income on their own returns.5Office of the Law Revision Counsel. 26 USC 661 – Deduction for Estates and Trusts Accumulating Income or Distributing Corpus The income keeps its character in the beneficiary’s hands, so qualified dividends stay qualified and tax-exempt interest stays exempt.6Office of the Law Revision Counsel. 26 USC 662 – Inclusion of Amounts in Gross Income of Beneficiaries of Estates and Trusts Accumulating Income or Distributing Corpus Each beneficiary gets a Schedule K-1 showing their share, which they report on Form 1040.7Internal Revenue Service. 2025 Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR
The deduction is capped by a concept called distributable net income. DNI is the trust’s taxable income with adjustments: capital gains allocated to principal are generally excluded, and tax-exempt interest is added back.8Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D Distributions up to DNI shift income from the trust to the beneficiary. Distributions above DNI are treated as tax-free returns of principal.
The numbers make the case. If a trust retains $20,000 of ordinary income, it owes roughly $5,330 in federal tax. If a beneficiary in the 22% bracket receives that same $20,000, they owe $4,400. Across years and multiple beneficiaries, the savings add up fast.
The 3.8% Investment Income Surtax
Non-grantor trusts also face a 3.8% net investment income tax on the lesser of their undistributed net investment income or the amount by which adjusted gross income exceeds the threshold where the top bracket begins.9Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax For 2026 that threshold is $16,000.4Internal Revenue Service. Revenue Procedure 2025-32 Net investment income covers interest, dividends, capital gains, rents, and royalties. A trust with $50,000 in undistributed investment income could owe an extra $1,292 on top of regular tax. Distributing income cuts the trust’s AGI and can eliminate the surtax entirely.
What Gets Skimmed Off Before Beneficiaries See a Check
A trust’s gross earnings and what beneficiaries actually receive are two different numbers. Administrative costs reduce returns every year.
Professional trustee fees are the largest ongoing expense. Corporate trustees typically charge between 0.5% and 1.5% of assets under management annually, with larger trusts paying lower percentage rates. On a $1 million trust, that’s roughly $10,000 a year in trustee fees alone. Individual trustees sometimes serve without compensation, especially family members, but they can claim reasonable fees under state law if the trust document permits.
Beyond trustee fees, the trust pays for tax return preparation (Form 1041 is not a simple return), legal advice when questions come up about the trust document, investment management fees when the trustee delegates to an outside advisor, and accounting costs for tracking income and principal separately. Real estate held in trust adds property management, insurance, and maintenance.
The deductibility of these costs is shifting. From 2018 through 2025, the Tax Cuts and Jobs Act suspended most miscellaneous itemized deductions, including some trust administration expenses. Starting in 2026, those deductions become available again for expenses that exceed 2% of the trust’s adjusted gross income.7Internal Revenue Service. 2025 Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR Costs unique to trust administration, meaning expenses that wouldn’t exist if the assets were held individually, have always stayed fully deductible even during the suspension years. Trustee fees relating solely to trust management fall into that protected category, though the line between protected and suspended expenses has been a continuing source of dispute.