I had a client a few years back who had me draft a trust for them, one that needed its own separate tax return. The client also hired me prepare the tax return for the trust after the first year of the trust’s existence. After the next year, the client decided that I was too expensive in preparing the taxes and hired someone else to do the tax preparation. I didn’t think much of that, until the client called and was very upset that the trust I created was so expensive on taxes.
Apparently the other tax preparer had calculated tax on the value of all assets contributed to the trust instead of just the income those assets generated. The tax preparer had confused transferring assets to the trust – the funding of the trust – with income to the trust, so the tax bill looked enormous. After seeing that was the case, I showed them where the error was and told them how to correct the problem.
I pointed them to a CPA who could help them get the tax returns corrected, as I no longer wished to assist them in tax preparation, but it struck me that doing things incorrectly can be much more expensive than paying for it to be done right the first time.
Tax preparation is only part of the equation when it comes to taxation of trusts and the tax implications of an estate plan. People usually want to save taxes using a trust, but for some trusts, taxes can actually be higher than those an individual would pay, so picking the right structure for a trust is important.
How Are Trusts Taxed: Yes! You Can Reduce Your Taxes With A Trust
I do think that when people think of saving taxes on a trust, their first thought is of savings on estate taxes. This type of thinking makes sense given some of the historical estate tax rates. In the past, estate taxes would apply to any amount over $600,000, or $1 Million, or even more recently, $5 Million. With a $1 Million dollar estate tax limit, and the value of real estate increasing, many couples found themselves in a situation where the needed to split which asset were owned by each spouse, in order to reduce the taxable estate. This led to many trusts being set up as marital deduction trusts, or separate trusts for each spouse. This would reduce the taxable estate for each spouse, and the overall estate tax. This was a popular form of estate planning in the past, and remains so today.
Watch Out – Tax Reform Has Come Around
However, with the passage of the American Tax Relief Act in early 2013, and subsequent tax reform, the rules have changed. The American Tax Relief act passed into law a provision for portability of the estate tax exemption between spouses. This means that if one spouse does not use their full estate tax exemption, the $1 Million previously mentioned, then the surviving spouse can use the deceased spouse’s unused exemption. Immediately prior to the passage of the American Tax Relief Act, the estate tax exemption was set at $5 Million. The American Tax Relief Act made this number permanent, which means until Congress changes its mind.
Congress changed its mind in late 2017, and reset the estate tax limit at $11.2 Million dollars per person. This means that if you have less than $11.2 Million dollars per person, or $22.4 Million dollars for a couple, your estate will not be subject to estate tax when you pass away, at least on the federal level. States can have their own inheritance or estate taxes. If someone has over the estate tax limit, assets can be put into an asset protection trust, but for most people a trust will not save them any estate tax, since most likely nothing would be due for estate tax anyhow!
Estate tax is not the only tax that affects a transfer of assets, as income tax can rear its ugly head.
How Are Trusts Taxed: The Impact of Income Tax
Just because your estate is not subject to estate, or inheritance tax, does not mean that you are out of the woods on tax matters. Income taxes, including capital gains tax need to be planned for and are quite important. Generally, when someone dies, a capital asset – like a house, or stocks, or other investment assets – will receive a stepped up basis to fair market value when the person dies, so that the heirs will inherit an asset that can be sold, but no tax would be due on the proceeds because tax on capital assets is only due on the sales price, minus cost-basis. If those numbers are the same, no capital gains tax would be due.
Not All Assets are Treated the Same
Not all assets get a step up in basis. Assets held in an annuity, or a qualified investment account like an IRA, Roth IRA, 401(k), 403(b) plan, or Thrift Savings plan, do not get a stepped up basis because of the favorable tax treatment that such investments received throughout someone’s lifetime. So, when someone dies and transfers a qualified investment to their heirs, income taxes will still apply. An IRA can be paid out in different ways, either as a lump sum, or the IRS will allow a payout over 5 years, or the IRA can be rolled into an inherited IRA.
The lump sum payments and 5 year payouts are subject to income tax as a distribution, so income tax will be due on the money distributed, including a 10% penalty to the recipient if the recipient is under 59 ½ years old. Transferring money into an inherited IRA allows the money to continue to receive the favorable tax treatment that the money received in the original IRA, and will be subject to the income tax rules regarding distributions, but the transfer from the original IRA to the inherited IRA will not be taxed as a distribution.
IRAs and Trusts
If an IRA is to pay out to a trust, then an inherited IRA is not going to be possible, but you can create a Stretch IRA, which functions the same way, preserving the advantageous tax attributes of an IRA, but inside of a trust, and making the transfer of IRA money into the trust a non-taxable event. Many of my clients do this as a form of tax planning, so that they save their children, or their heirs, the trouble of trying to figure out how to receive the money on their own, potentially making a tax mistake, which could cost 50% or more of the IRA money in taxes to the IRS and the state in which you live.
Plan Ahead to Minimize Taxes
Most people prefer to get their money to their children or heirs, not to the government. I tend to agree with that approach. I would much rather your money get where you want it to go, and not to the government, but making sure that happens is the product of careful planning. We can create a plan to make this happen, using a trust, or using another vehicle. If you would like to discuss what would work best for you, please schedule an appointment here.