What must a trust do according to tax regulations?

A trust must generally distribute its income to its beneficiaries according to the terms specified in the trust agreement. This is significant because many trusts are structured to pass their income directly to beneficiaries, allowing them to potentially avoid higher trust tax rates. The distributions also fulfill the requirements of the trust regarding how it is operated and taxed.

When a trust distributes its income, it typically allows the beneficiaries to report that income on their own tax returns, which can lead to tax benefits for both the trust and the beneficiaries. This is particularly relevant for certain types of trusts classified as "simple trusts," which are required by law to distribute all their income to beneficiaries annually.

In contrast, retaining all earnings would mean the trust might be subject to higher tax brackets, as trusts are taxed much more heavily on undistributed earnings compared to individuals. Investing solely in municipal bonds could limit the trust's income diversification strategy and does not pertain to the requirements set forth for distributions. Lastly, making periodic payments to the trust's creator is not a general requirement for trusts and usually applies only in specific arrangements where the trust was designed to provide for its creator during their lifetime.