Practice Areas
Estate Planning
Trusts
Probate
Practice Areas
When researching the topics of trusts and trust administration, Woodland Hills residents may likely hear the terms “principal” and “income” thrown around quite a bit. If you’re involved in administering a trust, understanding the terms “principal” and “income” is essential. These two components determine how trust assets are classified, taxed, and ultimately distributed.
Knowing the difference between principal vs income trust designations is key for trustees, especially when complying with California’s Probate Code and the terms of the trust. Accurate classification affects everything from distributions to beneficiaries to income taxes and long-term asset protection.
As defined by the American Bar Association, what is principal trust property? It refers to the original trust assets placed into the trust to benefit beneficiaries. This may include:
A trust’s principal can be gained or lost by the grantor adding to it or through any gains or losses made through the sale of trust property. Judgments awarded to the trust through a lawsuit are also considered to be additions to principal.
For taxable income and income tax purposes, principal is not considered ordinary income. Instead, it is a long-term holding that may influence estate taxes and must be reflected accurately in tax returns.
What is trust income in relation to principal? Income refers to any earnings generated by the trust’s principal. This may include:
Income is any earnings generated by the principal, such as interest earned from trust accounts, dividends from stock holdings, or rental fees generated by trust properties. Asset allocations made from the trust will either come from its income or principal.
The difference between trust principal vs income determines how the income distributions are handled. Distributions to beneficiaries may be taxed as ordinary income, depending on the type of trust—such as a simple trust or a grantor trust.
Understanding principal vs income is essential for trustees. Whether income is retained or distributed impacts the trust’s tax returns and the taxable income of beneficiaries. For income tax purposes, income is usually taxed at the individual beneficiary’s rate, while principal may be shielded for asset protection or estate planning purposes.
Investment managers must also understand this distinction, as it influences how assets managed by the trust are allocated. A trustee’s failure to properly distinguish between the two can lead to disputes or legal issues.
According to the California Probate Code, receipts and/or disbursements from a trust’s principal and income are to be determined by the trustee in a clearly defined order. First, he or she is expected to make trust allocations in accordance with the trust instrument or will that created it. If no such provisions are included but such documents do empower him or her to use his or her own discretion, then he or she may do so. If no such language is present in any estate documents, the trustee is expected to allocate a trust’s principal and income according to the Probate Code.
A qualified income trust (QIT), also known as a Miller Trust, is a specific type of trust often used in Medicaid planning. It allows individuals with income above Medicaid eligibility limits to qualify by diverting excess income into a trust.
While not used in California, QITs are important for families in states where Medicaid rules are stricter. In all cases, understanding principal vs income remains critical to ensure proper compliance and accurate distributions to beneficiaries.
Need help understanding trust administration, principal and income rules, or how your trust affects income taxes and estate taxes? At the Law Offices of Alice A. Salvo, we can guide you through every aspect of your estate plan, trust creation, or trust management. Contact our team today for trusted legal support in Woodland Hills and throughout Los Angeles.