TRUSTS & TAXES: WHAT YOU NEED TO KNOW

People often have questions or confusion about how trusts can help save on taxes. Given how frequently this topic comes up, it’s essential to understand the tax implications associated with different types of trusts. Here's a guide to help clarify these issues.

TWO TYPES OF TRUSTS

There are two primary types of trusts: revocable living trusts and irrevocable trusts. Each comes with distinct tax consequences.

REVOCABLE LIVING TRUST

A revocable living trust, commonly referred to as a living trust, is the most frequently used trust in estate planning. As long as you are alive, creating a living trust has no tax impact.

This type of trust uses your Social Security Number as its tax identifier and is not considered a separate entity from you for tax purposes. However, a living trust is distinct for the purpose of avoiding probate, which often causes confusion regarding taxes. Before diving into the tax implications, let's first explain how a living trust functions.

A living trust is an agreement where the grantor transfers assets to a trustee, who holds them for the benefit of the beneficiaries. With a revocable living trust, there are no tax consequences because you can revoke the trust agreement or retrieve the assets from the trustee at any time. You can also change the terms of the trust, the trustee, the beneficiaries, or terminate the trust altogether while you are alive.

The trust becomes irrevocable if you become incapacitated or upon your death. At that point, the trustee takes over the management of the trust assets and will apply for a tax ID number for the trust. The trust then becomes a taxable entity, and any income earned that is not distributed within that year is subject to income taxes at the trust’s tax rates (or the beneficiaries' tax rates if income is distributed to them).

IRREVOCABLE TRUSTS

An irrevocable trust is established when you make a gift to a trustee to hold assets for a beneficiary, and you cannot reclaim the gift. This trust can be created during your lifetime, at death through a testamentary trust (arising from your will), or through a revocable living trust established while you are alive. The trust is a separate tax-paying entity and is subject to income tax on the trust's earnings, either at the trust’s tax rates or the beneficiaries' rates.

As the name suggests, an irrevocable trust’s terms cannot be changed, and it cannot be terminated once executed. When you transfer assets into an irrevocable trust, you relinquish ownership, and the trustee takes control of the assets. These assets are no longer part of your estate and, if maintained properly, are protected from lawsuits, creditors, divorce, serious illness, accidents, and even bankruptcy.

However, irrevocable trusts do have tax consequences. As of 2022, income earned by an irrevocable trust is taxed at the highest individual tax bracket of 37% once undistributed taxable income exceeds $13,450. To avoid this high tax rate, some irrevocable trusts can be structured so that the tax consequences pass through to the beneficiary, typically resulting in lower taxes.

THE ESTATE TAX: WHAT IT IS & WHO PAYS IT

The estate tax is levied on the value of a person’s assets at death. If the total value of your estate exceeds a certain threshold, known as the federal estate tax exemption, the IRS requires your estate to pay a tax before assets can be passed to beneficiaries.

As of 2022, the federal estate tax exemption is $12.06 million for individuals ($24.12 million for married couples). If your estate is worth $12.06 million or less, no federal estate tax is owed. However, if your estate exceeds this amount, the excess is taxed at 40%.

Various estate planning strategies can reduce or eliminate estate tax liability, often involving irrevocable trusts. While these strategies can be complex, they are worthwhile if they save your family from a significant tax burden.

THE FUTURE ESTATE TAX

The current $12.06 million estate tax exemption is set to expire on January 1, 2026, reverting to its previous level of $5 million, adjusted for inflation to about $6.03 million. The estate tax exemption at the time of your death and the value of your assets are uncertain. Therefore, it’s crucial to implement planning strategies to protect your estate from taxes, regardless of future changes.

CONCLUSION

Deciding between a revocable living trust, irrevocable trust, Lifetime Asset Protection Trust, or another estate planning vehicle is crucial for maximizing benefits and minimizing taxes for your loved ones. Ensure your estate plan is up-to-date and designed to adapt to changes in your life, assets, and the law.

This article is a service of Zarda Law, S.C. We do not just draft documents; we ensure you make informed decisions about life and death, for yourself and the people you love. That's why we offer Legacy Planning Session, during which you will get financially organized and make all the best choices for the people you love. You can begin by scheduling a Legacy Planning Session and mention this article to find out how to get this $750 session at no charge.