Trusts & Taxes: What You Need to Know
People often come to me curious — or confused — about the role trusts play in saving on taxes. Given how frequently this issue comes up, here I’m going to explain the tax implications associated with different types of trusts in order to clarify this issue.
TWO TYPES OF TRUSTS
There are two primary types of trusts — revocable living trusts and irrevocable trusts — and each one comes with different tax consequences.
REVOCABLE LIVING TRUST
A revocable living trust, also known simply as a living trust, is by far the most commonly used form of trust in estate planning. And as long as you are living, there is absolutely no tax impact of creating a living trust.
A living trust uses your Social Security Number as its tax identifier, and this type of trust is not a separate entity from you for tax purposes. However, a living trust is a separate entity from you for the purpose of avoiding the court process called probate, and this is where the confusion regarding taxes often comes from. But before we explain the tax implications of a living trust, let’s first describe how a living trust works.
A living trust is simply an agreement between a person known as the grantor, who gives assets to a person or entity known as a trustee, to hold those assets for the benefit of a beneficiary(s). In the case of a revocable living trust, the reason there are no tax consequences is because you can revoke the trust agreement or take the assets back from the trustee at any time, for any reason. In fact, as long as you are living, you can change the terms of the trust, change the trustee, change the beneficiaries, or terminate the trust altogether.
The revocable living trust becomes irrevocable when you die. At that point, the trustee you’ve named will step in and take over management of the trust assets, and one of the first things that your trustee will do is to apply for a tax ID number for the trust. At this point, the trust becomes a taxable entity, and any income earned inside of the trust that is not distributed in that year would be subject to income taxes, at the taxable rates of the trust (or at the tax rates of the beneficiaries, if income is distributed to the beneficiaries).
An irrevocable trust is created when you make a gift to a trustee to hold assets for the benefit of the beneficiary, and you cannot take back the gift you’ve made to that individual.
When you create an irrevocable trust, either during your lifetime, or at death through a testamentary trust (a trust that arises at the time of your death through your will), or through a revocable living trust creating during your lifetime, the trust is a separate tax-paying entity, and it is either subject to income tax on the earnings of the trust at the rates of the trust or at the rates of the beneficiaries.
Unlike a revocable living trust, an irrevocable trust is (as the name implies) irrevocable. This means that the trust’s terms cannot be changed, and the trust cannot be terminated once it’s been executed. When you transfer assets into an irrevocable trust, you relinquish all ownership of those assets, and your chosen trustee takes total control of the assets transferred into the name of the trust. Because you no longer own the assets held by the trust, those assets are no longer considered part of your estate, and in some circumstances, as long as the trust has been properly maintained, the assets held by the trust are also protected from lawsuits, creditors, divorce, serious illness and accidents, and even bankruptcy.
However, as mentioned earlier, irrevocable trusts also come with tax consequences. As of 2022, the income earned by an irrevocable trust is taxed at the highest individual tax bracket of 37% as soon as the undistributed taxable income reaches more than $13,450. To avoid this high tax rate, in some cases, an irrevocable trust can be prepared so that the tax consequences pass through to the beneficiary and are taxed at his or her rates, which are typically much lower.
THE ESTATE TAX: WHAT IT IS & WHO PAYS IT
The estate tax is a tax on the value of a person’s assets at the time of their death. Upon your death, if the total value of your estate is above a certain threshold amount, your estate must pay a tax, known as the estate tax, before any assets can be passed to your beneficiaries. There is a federal estate tax and a Maine estate tax.
As of 2022, the federal estate tax exemption is $12.06 million for individuals ($24.12 million for married couples). Simply put, if you die in 2022, and your assets are worth $12.06 million or less, your estate won’t owe any federal estate tax. However, if your estate is worth more than $12.06 million, the amount of your assets that are greater than $12.06 million will be taxed at a whopping 40% tax rate. in 2022, the Maine estate tax exemption is $6.01 million.
You can reduce your estate tax liability—or even eliminate it all together—by using various estate planning strategies.
THE FUTURE ESTATE TAX
The current $12.06 million federal estate tax exemption is set to expire on Jan. 1, 2026, and return to its previous level of $5 million, which when adjusted for inflation is expected to be around $6.03 million. Here’s one thing we know for sure: We don’t know what the estate tax exemption will be at the time of your death, and we also don’t know what the value of your assets will be at the time of your death. Because of this, when you plan with me, I will ensure that I put in place planning strategies to protect your estate from estate taxes, regardless of the amount of the estate tax exemption or the size of your assets.
I’M HERE FOR YOU
If you are trying to decide whether a revocable living trust, irrevocable trust, or some other estate planning vehicle is the right solution for you and your family, click here to schedule an initial call with me. I will support you in making that decision, so your estate can provide the maximum benefit for the people you love most, while paying the least amount of taxes possible.