If your estate plan includes one or more trusts, review them in light of income taxes. For trusts, the income threshold is very low for triggering the:
- Top income tax rate of 39.6%,
- Top long-term capital gains rate of 20%, and
- Net investment income tax (NIIT) of 3.8%.
The threshold is only $12,500 for 2017.
3 ways to soften the blow
Three strategies can help you soften the blow of higher taxes on trust income:
- Use grantor trusts. An intentionally defective grantor trust (IDGT) is designed so that you, the grantor, are treated as the trust’s owner for income tax purposes — even though your contributions to the trust are considered “completed gifts” for estate- and gift-tax purposes.
IDGTs offer significant advantages. The trust’s income is taxed to you, so the trust itself avoids taxation. This allows trust assets to grow tax-free, leaving more for your beneficiaries. And it reduces the size of your estate. Further, as the owner, you can sell assets to the trust or engage in other transactions without tax consequences.
Keep in mind that, if your personal income exceeds the applicable thresholds for your filing status, using an IDGT won’t avoid the tax rates described above. Still, the other benefits of these trusts make them attractive.
- Change your investment strategy. Despite the advantages of grantor trusts, nongrantor trusts are sometimes desirable or necessary. At some point, for example, you may decide to convert a grantor trust to a nongrantor trust to relieve yourself of the burden of paying the trust’s taxes. Also, grantor trusts become nongrantor trusts after the grantor’s death.
One strategy for easing the tax burden on nongrantor trusts is for the trustee to shift investments into tax-exempt or tax-deferred investments.
- Distribute income. Generally, nongrantor trusts are subject to tax only to the extent they accumulate taxable income. When a trust makes distributions to a beneficiary, it passes along ordinary income (and, in some cases, capital gains), which are taxed at the beneficiary’s marginal rate.
Thus, one strategy for minimizing taxes on trust income is to distribute the income to beneficiaries in lower tax brackets. The trustee might also consider distributing appreciated assets, rather than cash, to take advantage of a beneficiary’s lower capital gains rate.
Of course, this strategy may conflict with a trust’s purposes, such as providing incentives to beneficiaries, preserving assets for future generations and shielding assets from beneficiaries’ creditors.
If you’re concerned about income taxes on your trusts, contact us. We can review your estate plan to uncover opportunities to reduce your family’s tax burden.