How Trusts Divide Principal and Income: Who Gets What, and When

Quick Insights

• Many trusts divide their money into two buckets. Principal is the property the trust holds. Income is what that property earns.
• The split matters because different people are often entitled to each bucket: one person receives the income now, and others receive the principal later.
• The trust document sets the rules first. If it's unclear or doesn’t explicitly address the situation, state law fills in the gaps.

A trust is a legal arrangement where one person, the trustee, manages money or property for the benefit of others, the beneficiaries. The person who creates the trust sets the rules in a written document, and the trustee's job is to follow them.

Many trusts have two kinds of beneficiaries. A common example: a parent leaves money in trust so that their surviving spouse receives the trust's income for the rest of their life, and the children receive whatever is left after that. The spouse is the income beneficiary. The children are the remainder beneficiaries.

To make that arrangement work, the trustee has to sort every dollar that comes in or goes out into one of two buckets: principal or income. This article explains what those buckets are, how money gets sorted between them, and why the sorting affects both what each beneficiary receives and how much tax gets paid.

What Principal and Income Mean

The easiest way to picture it is a fruit tree.

Principal is the tree: the money or property that was put into the trust, plus anything it's later exchanged for. If the trustee sells a stock and uses the money to buy a bond, the bond is still principal.

Income is the fruit: what the tree produces each year, such as interest on a bond, dividends on a stock, or rent from a building.

The income beneficiary gets the fruit. The remainder beneficiaries eventually get the tree.

These buckets are about who's entitled to what under the trust. They're different from what the IRS counts as income for tax purposes, which is why the same dollar can be "principal" to the trust and still show up as taxable income on the trust's tax return.

A Simple Example

Say a married couple puts about $2 million in investments into a revocable living trust. While they're both alive, they're typically their own trustees, and they're entitled to everything in the trust, both the principal and the income. They can spend the interest, sell investments, or change the trust's terms, and the trust's earnings are generally reported on their own tax return. Because the same two people are entitled to both buckets, the split has little practical effect at this stage.

Now suppose the trust document says that when the first spouse dies, the trust becomes irrevocable. The surviving spouse is entitled to the income for the rest of their life, and the children will receive what's left after that. From this point on, the two buckets now benefit different people.

In one year after the first spouse’s death, the trust earns $40,000 in interest and ordinary cash dividends. The trustee also sells stock that has increased in value by $100,000 since the death of the first spouse.

Assuming the trust follows the usual allocation rules, with no principal distributions or adjustments, and ignoring expenses and taxes:

• The $40,000 of interest and dividends is income, so it goes to the surviving spouse.
• The $100,000 gain is added to principal, so it remains invested in the trust. The children will receive whatever principal remains when the surviving spouse dies.

The spouse might be surprised to receive $40,000 when the trust also realized a $100,000 gain. But under these assumptions, that’s the expected result: the interest and dividends are fruit from the tree, while the gain becomes part of the tree itself.

Who Decides What Goes Where

Every time money comes into the trust or goes out of it, the trustee has to decide whether it counts as principal or income. They should do so by consulting:

1. The trust document. If the document says how something should be handled, that's the answer.
2. State law. If the document doesn't specify, state law provides default rules. New York's rules are in Article 11-A of its Estates, Powers and Trusts Law, and Michigan's are in its Uniform Principal and Income Act. Both follow a similar national model. This is often preferred when a trust document is drafted because these laws are comprehensive, cover situations the drafter can't predict, and get updated over time.

The trustee also has a duty to be fair to both sides. They can't quietly favor the income beneficiary or the remainder beneficiaries unless the trust document allows it.

It's also worth knowing that the income split sets what the income beneficiary is entitled to automatically. Many trusts also allow the trustee to give that beneficiary some principal when needed, for things like health care, education, or living expenses. That's a separate decision from the income split.

If you've just been named a trustee, our guide on what to do when you've been named a trustee walks through the rest of the role.

How Common Items Are Usually Sorted

Here's how the most common items are typically handled when the trust document doesn't say otherwise:

A few items are trickier than this table suggests. Payments from retirement accounts and money from a business the trust owns follow special rules, and they're easy to get wrong. If a trust holds either one, it's worth having a CPA confirm how they should be handled.

When the Usual Rules Feel Unfair

Many trust investments today are aimed at long-term growth. That can mean the investments increase in value nicely while paying out relatively little interest or dividends. Under the usual split, the income beneficiary ends up with a small check even when the trust is doing well overall.

State law gives trustees ways to address this. In both New York and Michigan, trustees can in some situations shift money between principal and income to keep things fair. New York also lets certain trusts switch to a fixed-percentage approach, where the income beneficiary receives 4% of the trust's value each year, no matter how much the investments actually earned.

These options come with conditions, and a beneficiary can challenge them. A trustee considering either one should get professional advice first.

How the Split Affects Taxes

The split also decides who pays tax on the money. Income that's paid out to the income beneficiary is generally taxed on that beneficiary's personal return. Gains that stay in principal are generally taxed to the trust itself.

That difference can be significant, because trusts hit the highest tax rates at very low income levels. In 2026, a trust reaches the top 20% federal rate on capital gains once its taxable income passes $16,250. A married couple filing jointly doesn't reach that rate until $613,700. An additional 3.8% tax on investment income can also apply.

In the example above, that means the $100,000 gain kept for the children is likely to be taxed at a higher rate inside the trust than it would have been on most individuals' returns. Our article Form 1041 Explained covers how trust tax returns work in more detail.

Getting the Split Right From the Start

The principal and income split can sound technical, but the idea is simple: the tree goes to one set of beneficiaries, and the fruit goes to another. The trust document sets the rules, state law fills in the gaps, and the trustee's job is to sort each dollar fairly and keep good records of how they did it.

Mistakes tend to build on each other. An item put in the wrong bucket in the first year carries forward into every year after, and it usually comes to light when a beneficiary asks why their payments look the way they do. If you're still getting oriented, our explainer on the difference between a trustee and an executor is a good place to start.

Revonary's trust accounting services help trustees in New York, Michigan, and beyond keep clear records, sort income and principal correctly, and prepare the trust's tax returns. Contact Revonary to talk through the trust you're involved with and what it requires.