Why Income Left in a Trust Hits the Top Tax Bracket So Much Faster Than Yours

Say the same dividend lands in a trust in two different years. One year the trustee pays it out to a beneficiary, and the next year the trust holds it. Those two years can produce very different tax bills. The gap comes from one rate table in the Internal Revenue Code and one decision the trustee makes: hold the income or distribute it. For families with large portfolios inside non-grantor trusts, that decision comes back every year.

How Section 1(e) Squeezes Trust Income

Under 26 U.S.C. § 1(e), every estate and every trust pays income tax on its own rate schedule. The version of that table at 26 U.S.C. § 1(j)(2)(E) squeezes the brackets hard. Using the statute’s base-year figures, written for 2018, a trust paid 37% on taxable income over $12,500. The single-filer table for that same base year, at § 1(j)(2)(C), didn’t reach 37% until $500,000. That sets the individual threshold at 40 times the trust’s.

The dollar amounts in the law are base-year figures, and the IRS adjusts them for inflation every year. For tax year 2026, the IRS says the top rate remains 37% for individual single taxpayers with incomes greater than $640,600 ($768,700 for married couples filing jointly). The indexed rate schedules for that year are published in Revenue Procedure 2025-32, which is the place to find this year’s trust figure. Both tables are indexed in the same way, so the trust schedule still runs out of lower brackets at a small fraction of the income a single filer needs to reach the top rate.

Only Income Kept Inside the Trust Gets Squeezed

The tight brackets apply to the taxable income of a non-grantor trust: the interest, dividends, rents and gains it earns and holds onto. The money used to fund the trust (its principal) isn’t income, so the squeeze hits the yearly earnings that build up. The trust document and state law decide what counts as distributable “income” under § 643(b).

Trust portfolios tend to produce exactly that kind of earnings. On estate tax returns filed in 2024, publicly traded stock was the largest asset category, at $71,266,601,000 across 7,195 returns.

How Payouts Move the Tax Bill to Beneficiaries

Distributable net income (DNI), defined in § 643(a), sets the most a trust can shift to beneficiaries in a year. Under § 661(a), the trust deducts amounts it pays out or is required to pay out, but “such deduction shall not exceed the distributable net income.” The beneficiary then reports those amounts as income under § 662(a). Under § 662(b), each item holds the same character it had inside the trust. The IRS explains that beneficiaries receive their share on Schedule K-1 (Form 1041), and that “there is never a double tax.”

Worked Example

A hypothetical non-grantor trust earns $100,000 of interest and dividends and has no expenses. The trustee pays $60,000 to an adult beneficiary. That payout is within DNI, so the trust deducts the full amount. The beneficiary reports $60,000 at her own rates, holds the same mix of interest and dividends. The trust holds $40,000, and that amount is taxed on the trust’s schedule, which reaches 37% long before an individual’s would.

65-Day Election Gives Trustees Extra Time

Under § 663(b)(1), an amount paid in the first 65 days of a trust’s tax year can be treated as paid on the last day of the year before. The rule applies only if the fiduciary elects it, “in such manner and at such time as the Secretary prescribes by regulations.” This lets a trustee wait until the books close, see the trust’s actual income and the beneficiaries’ situations, and then decide. If the trustee forgets to make the election, the payout counts toward the new year instead.

Grantor Trusts Avoid the Squeeze Entirely

When the person who created the trust (the grantor) is treated as its owner, § 671 sets the trust’s income, deductions and credits on the grantor’s own return. The IRS confirms that this income “is taxable to the grantor, not the beneficiary” when the grantor holds certain controls. The problem comes when grantor status ends, usually at the grantor’s death. From then on, the trust is its own taxpayer and the compressed brackets apply.

3.8% Surtax Starts at the Same Low Point

Under § 1411(a)(2), trusts owe a 3.8% tax on whichever is smaller: undistributed net investment income, or adjusted gross income above “the dollar amount at which the highest tax bracket in section 1(e) begins.” For individuals, the starting point is a separate “threshold amount” under § 1411(a)(1)(B)(ii). Investment income a trust holds can therefore face both the top income tax rate and the surtax.

Questions to Ask Before Paying Out Income

• Compare marginal rates. A beneficiary already in the 37% bracket saves little on income tax. A beneficiary with a modest income may save a lot.
• Consider the trust’s purpose. Trusts built for creditor protection, beneficiaries who struggle with money, or eligibility for government benefits can lose those protections when cash goes out. A tax saving may not be worth it.
• Check young beneficiaries. Unearned income paid to a child can be taxed at the parents’ rates under the kiddie tax, which cuts into the savings.
• Map separate shares. In a trust with more than one beneficiary, § 663(c) treats substantially separate shares as separate trusts when calculating DNI.

Paying out income fits trusts whose beneficiaries are in lower brackets and need no protection. It works poorly when holds control of the assets is the reason the trust exists.

What to Watch Heading Into 2027

The IRS has already raised the top single threshold for tax year 2027 to $661,375. Look for the matching trust schedule in that year’s revenue procedure. The 65-day window for 2026 trust income opens on January 1, so trustees need beneficiaries’ income estimates and DNI projections ready before year-end.

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