Trusts can be a great way to protect your assets. They may even help you avoid probate for your beneficiaries when you die, or excessive costs when transferring your wealth. There are two types of trusts, one of which is taxed normally and another that may minimize your income taxes.
In short, the trust owns the assets, but you can set up a revocable or irrevocable trust, which makes a big difference in your taxation.
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What is a Revocable Trust?
With a revocable trust, you are the grantor of the trust or the owner. The money is in the trust, separate from your assets, but you can make changes to the trust and withdraw funds at any time.
In a revocable trust, you are the trust maker, also known as the trustor or grantor. But with a revocable trust, you are likely the trustee too or the person who handles all aspects of the trust. This includes tracking the income and reporting it to the IRS for tax reasons.
You can remain a trustee if you are of sound mind. You may also name a successor trustee to take over when you are no longer able to make decisions. You can change beneficiaries, remove assets, and make other financial changes to the trust throughout your lifetime.
This also means you’re responsible for reporting all income and deductions on your personal tax return. For example, if you put your stocks in the trust and then you sell them for a capital gain, you must report the capital gains on your tax returns and pay the applicable taxes, either short-term or long-term gains taxes.
This could increase your tax liability as it’s added to your individual tax return since you can make changes to the trust.
What is an Irrevocable Trust?
An irrevocable trust cannot be changed. Once you put assets in it, they remain there. You cannot make changes or withdraw the funds. You name a grantor other than yourself which removes the tax liability from you.
In an irrevocable trust, you are still the trust maker, also known as the trustor or grantor, but you are not the trustee. You appoint trustees or beneficiaries – they are the only people who can make changes to the trust, but only under certain circumstances. If you include instructions to your trustees to make changes under certain circumstances, they may be able to make those changes, but you cannot make any changes.
The good news, though is whatever property or assets you move to the irrevocable trust are no longer your tax liability. If they earn income, the trust owes the taxes, not you. The trust is now a separate entity. This may help keep you in a lower tax bracket especially if you put a large number of your assets in the trust.
Any capital gains, equity, or interest earned becomes the tax liability of the trust. Since the trust only has the assets you put into it, chances are it will be in the lowest tax bracket which means you’ll keep more of your assets in your trust rather than paying them out to the IRS.
Estate Tax Exemptions
The benefits continue upon your passing. If your estate is worth less than $11.7 million, your estate won’t owe taxes. This means your beneficiaries can distribute your assets without worrying about taxes. Any amount over $11.7 million, however, is subject to income tax between 18% – 40% depending on the value.
What are the Downsides?
There are plenty of tax benefits of placing your assets in a trust, but there are some downsides too. Since a trust is taxed just like an individual, there are income tax brackets. Unlike individuals, though, the threshold for those tax brackets is much lower.
For example, a trust with an income of $13,051 is in the highest tax bracket (37%). Compare that to an individual tax return with a single filer and they don’t reach the top tax bracket until their income exceeds $523,601 – that’s over a $500,000 difference. Married filing joint filers don’t hit the top tax bracket until they have ordinary earnings of over $628,301.
What if there are Distributions?
If a trust makes distributions throughout the year, it lowers its taxable income. This is often the chosen method since most beneficiaries will be in a lower tax bracket than the trust. This gives beneficiaries a larger payout while minimizing the taxes the trust pays.
Do Beneficiaries Pay Taxes?
Yes, beneficiaries can pay taxes on trust distributions IF there are earnings. They won’t pay taxes on the principal amount invested since that was likely already taxed (unless it’s a tax-deferred account).
If there are any earnings, such as capital gains on stocks, bond maturity, or capital gains in a home that’s sold, beneficiaries will owe taxes but at the individual tax rate. Since the individual tax rate is much lower than the trust tax rate, the taxes paid are typically much lower.
Trust taxes can get complicated. If you’re thinking of putting your assets in a trust for the tax benefits, talk with a licensed tax advisor. If you set up a revocable trust, you’ll still be on the hook for the taxes incurred within the trust. There are still benefits of opening a revocable trust, but if you’re doing it for the tax benefits, consider other options.
An irrevocable trust may provide the tax protection you desire, but keep in mind that trust tax rates are much higher than individual tax rates. Look at the big picture with your tax advisor to decide which option is right for your situation.