ONE OF THE MORE CONFUSING aspects of trust law is the difference between trust accounting income1 and gross income2 for Federal income tax purposes. The two are not necessarily the same! When a trustee conflates the two, this could lead to unintended consequences and potential liability. This is particularly true when dealing with a trust that is a beneficiary of an individual retirement account (“IRA”). My goal in this article is to outline the distinction between trust accounting income and gross income for Federal income tax purposes, with particular attention to trusts receiving distributions from an IRA. I will close with some practical advice for Illinois practitioners as they advise trustees.
An illustration
Assume you represent the trustee of an irrevocable trust established at a parent’s death for the benefit of an adult child. The trust directs all income to be paid to the child and also authorizes discretionary payments of trust principal for the child’s health, education, maintenance, and support. The trust is the designated beneficiary of the parent’s IRA.
In the first year of the trust, the trustee withdraws the required minimum distribution (“RMD”) from the IRA. What should the trustee do with this RMD? Should they pay it to the child pursuant to the trust directive requiring all income be paid to the child?
Under Illinois law, the answer is generally no. Absent contrary language in the trust document, a distribution received by a trust from an IRA is allocated to principal, not income. Accordingly, the RMD is not automatically distributable merely because the trust requires distribution of all trust accounting income.
IRA distributions are trust principal
When a trust mandates all income be paid to the trust beneficiary, the “income” referenced in the document is what is commonly referred to as “trust accounting income.” The Illinois Principal and Income Act defines trust accounting income, and section 12.1 of this Act has particular reference to how receipts from an IRA are treated:
(a) Except as provided in subsection (b), if any part of the principal consists of the right to receive periodic payments under an employment-related contract or plan or an individual retirement account or annuity, the receipts therefrom shall be allocated to principal.
When a trust is the beneficiary of an IRA, distributions received by the trust from the IRA are trust principal even though these IRA distributions are gross income for Federal income tax purposes.3
Returning to the illustration above, the RMD being paid to the trust is not trust accounting income, and the trustee should not transfer the amount to the child as such. The RMD is trust principal and should only be paid to the child if the trustee determines it is needed for the child’s health, education, maintenance, or support.
Balancing trust objectives and tax efficiency
The fact that distributions from an IRA to a trust are considered principal and could therefore potentially remain “trapped” in the trust creates income tax consternation for trustees and their legal counsel. Trusts have a highly compressed marginal income tax rate. In 2026, a trust reaches the highest 37% marginal tax bracket at $16,000 of gross income.4 This means even a modest amount of IRA distributions will push a trust into the highest marginal tax bracket.
Accordingly, trustees will instinctively look for ways to reduce the trust’s tax burden. One of the most common ways to do this is by shifting the tax burden to the beneficiary through trust distributions. When a trust’s taxable income is distributed to the beneficiary, the trust can take a deduction for the amounts distributed, and the beneficiary reports the income on their own personal tax return. Where beneficiaries are in a lower marginal tax bracket than the trust, this may reduce the overall income tax burden.
When a trust is named as a beneficiary of an IRA, the trustee must balance (i) the goals and purpose of the trust (for example, protecting the beneficiary from foolish spending decisions) with (ii) being tax efficient.5 This is not always an easy balance to strike. A trustee must resist the urge to reflexively distribute IRA receipts to the beneficiary. While distribution may result in a lower overall tax burden, the trustee must ensure such a distribution aligns with the directives contained in the trust.
Advising trustees
When it comes to advising trustees on these matters, Illinois practitioners must always come back to what the trust document says. Passing along the taxable income to the beneficiary is often a desirable objective, but the trustee must be authorized to do so!
Several considerations are worth keeping in mind:
- First, remember that tax efficiency is only one goal in administering a trust. The goals of a trust may be better accomplished by having the trustee retain IRA distributions as trust principal, even if it means the trustee pays tax at a higher marginal rate.
- Second, gross income for Federal income tax purposes can be distributed to a trust beneficiary through a distribution of trust principal.
- Third, review the provisions of the trust document. Many documents directly address how the trustee should handle distributions received from an IRA. For example, a trust that my bank was administering had the following clause buried in the trustee powers section:
“If the trust is the beneficiary … of an individual retirement plan, income earned after death in the account shall be income of the trust, and if the trustee is required to pay all trust income to a beneficiary, the trustee shall collect and pay the income of the account to the beneficiary at least quarterly…”
Since this trust requires the trustee to pay income to the beneficiary, this clause then requires the trustee to track the income generated within the IRA, withdraw it, and then pay it to the beneficiary accordingly.
Drafting considerations
When preparing trust documents, it is advisable for Illinois estate planning practitioners to ensure the trust can handle IRA distributions. Some practical considerations:
- First, review how the trust document addresses trust accounting income and principal. The Illinois Principal and Income Act provides that trust documents may override the Act’s default rules. This means trusts are not stuck with IRA distributions always being considered principal! Consideration ought to be made if the default rule advances or frustrates the client’s goals.
- Second, always remember to consider your client’s objectives when drafting trust documents. A trust can be a “conduit trust” (requiring all IRA distributions to be paid directly to a beneficiary) or an “accumulation trust” (allowing a trustee to accumulate IRA distributions), and the difference between the two is not right versus wrong! The trust is a tool to accomplish the client’s objectives. Accordingly, a client who is primarily concerned about protection for their beneficiaries may prefer an accumulation trust even though the overall income tax burden may be higher.
- Third, review the “boilerplate” language in your form documents. In the scenario I outlined in the third bullet point of the “Advising Trustees” section above, I wonder if the attorney who prepared the trust realized the impact this form clause would have on the trust administration.
- Finally, because retirement plans are frequently the largest financial asset your estate planning clients will have, attorneys must develop a thorough understanding of the intricacies of retirement account distributions and how they relate to trusts. I recommend Natale Choate’s book,6 along with its 134-page update that is available on her website.7
Conclusion
The distinction between trust accounting income and federal taxable income is critical whenever a trust is the beneficiary of an IRA. Although IRA distributions are generally taxable when received by a trust, Illinois law ordinarily allocates those distributions to principal rather than income. Illinois attorneys and trustees must avoid assuming IRA distributions must be paid to an income beneficiary. Instead, careful analysis of the trust document and the trust’s overall objectives should be had before making distribution decisions.
Have questions about trust administration and how retirement assets are handled within a trust? Connect with a Trust Officer to learn more.
1. Trust income and principal are defined in the Illinois Principal and Income Act, 760 ILCS 15/4 (2025).
2. I.R.C. § 643(a).
3. I.R.C. § 408(d)(1) states “…any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee…”
4. I.R.C. § 1(e).
5. See the Illinois Prudent Investor Law, with reference to 760 ILCS 3/902(c)(3), which requires Illinois trustees, amongst many other considerations when investing trust assets, to weigh the expected tax consequences of investment decisions or strategies.
6. Natalie Choate, Life and Death Planning for Retirement Benefits (8th ed. 2019).
7. Ataxplan.com.
