If trusts are a component of your estate plan, there are several tax-advantaged trust strategies you can put into play to help keep your trusts intact. Since income thresholds can activate a reduction in your trusts, knowing more about the income thresholds before you file your next tax return is an exercise that can help you retain more of the trusts you’ve established. Taking a look back at your previously filed returns can point the way to how these thresholds impacted your trusts in the past so you can put strategies in place that can help you avoid tax consequences in the future.
Specifically, income thresholds can trigger:
- the highest income tax rate of 37%,
- the highest long-term capital gains rate of 20%, and
- a significant 3.8% net investment income tax.
Tax-Advantaged Trust Strategies
The following tax-advantaged trust strategies can help you offset the effects the previously referenced income threshold triggers can have on your trusts.
Intentionally Defective Grantor Trust
Using an Intentionally Defective Grantor Trust (IDGT) is the first tax-advantaged trust strategy that can keep more of your money inside your trust. An IDGT is crafted in such a way that you, the grantor, are treated as the trust’s owner for income tax purposes. Even though you are technically viewed as the owner when using an IDGT, your trust contributions are considered as “completed gifts” (defined by the IRS as gifts you no longer have control over) for estate and gift-tax purposes.
In this scenario, even though you are taxed for the trust’s income, the trust itself is able to avoid being taxed. In this way, the assets of the trust can grow tax-free so your beneficiaries inherit more. Additionally, this tactic reduces the size of your estate. As the owner, you’re also at liberty to sell assets to the trust or engage in other transactions without tax consequences.
It’s important to note that while the trust tax rates are the same as the individual tax rates, the brackets are much more compressed. For example, trusts reach the top tax bracket when taxable income exceeds $12,500 as compared to $600,000 for joint filers. While using an IDGT may not allow you to circumvent the threshold tax rates, the benefits of these trusts can minimize your tax consequence.
Converting a Grantor Trust to a Nongrantor Trust
The second tax-advantaged trust strategy involves converting your grantor trust to a nongrantor trust and making some alterations to your investment strategy as another effective way of minimizing your tax burden. If it becomes necessary for you to seek an alternative to paying grantor trust taxes, you may opt to convert the grantor trust to a nongrantor trust. Grantor trusts will automatically convert to a nongrantor trust when the grantor passes away. Switching up your investment strategy to move investments into either tax-exempt or tax-deferred investments can help ease the tax burden of a nongrantor trust.
Income Distribution to Beneficiaries
Finally distributing income to beneficiaries is another tax-advantaged trust strategy which will minimize taxes associated with your trusts. Nongrantor trusts are generally subject to tax only to the extent that they accumulate taxable income. Distributions made by a trust to the trust’s beneficiary pass along ordinary income (and, in some cases, capital gains), along with the distributions. This is then taxed at the beneficiary’s marginal rate.
By distributing the trust’s income to beneficiaries in lower tax brackets, taxes can be decreased. (Note, however, that this only works in the case where the trust isn’t already required to distribute income.) The trustee might also consider distributing appreciated assets, as opposed to cash, to take advantage of a beneficiary’s lower capital gains rate, though this may conflict with the trust’s intended purposes.
If you’re concerned about income taxes on your trusts, contact your Untracht Early advisor for further guidance on tax-advantaged trust strategies.