The principal and income act is the name for a body of law, which varies by state, which provides rules for determining whether earnings of a trust, for example, are to be characterized as income or principal. This can be illustrated with a simple example. If you set up a trust to pay income to your son John and on his reaching age 25 to pay the principal to your daughter Jane. If the trust invests in a CD, the interest on the CD would be paid to John as "income". If the trust purchased a stock, the dividends received on the stock would be income paid to John. If the stock appreciated in value and was sold, the capital gain would be generally treated as principal and allocated to what Jane would get. Two common concepts in the principal and income act in many states are the right to convert a trust that is set up as a simple income trust above into a uni-trust payment. This would have a fixed percentage, say 4% of the value of the trust paid each year to the current beneficiary instead of income. Another concept which many states have in their statute is a right for the trustee to make a transfer or "adjustment" as between income and principal. The principal and income act is far more complex and detailed then this simple illustration. Provisions in the actual trust document can modify how state law applies to the trust.
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