When creating an estate plan, using a trust is a way to make passing on assets – including cash and physical assets – a little easier. Using a trust can often help your family avoid a lengthy probate process after you die. Inheriting a trust comes with certain tax implications. The rules can be complex, but generally only the income of a trust is taxed, not the principal.
A financial advisor can help you minimize estate taxes by creating an estate plan for you and your family. Find a financial advisor today.
Basics of trust
A trust is simply a legal vehicle that can be filled with numerous assets, including cash and physical possessions. The person who creates the trust is known as the grantor. A trust is managed by a trustee. The trustee can be an individual or a company that manages the trust for the beneficiary. The beneficiary of the trust is the person who benefits from these assets. This beneficiary can be an individual, such as a child or other family member, or an organization such as a charity group.
Trusts are often used as a tool to minimize estate taxes. Although assets transferred through a will usually have to go through the probate process, trusts can usually bypass this step, speeding up the process and saving on legal costs.
Types of Trusts
There are quite a few types of trusts, but one of the biggest differences between trusts is whether they are revocable or irrevocable. A revocable trust can be amended at any time during the life of the person granting the trust, also called the grantor. The grantor can add or remove beneficiaries, add or remove assets from the trust, or terminate the trust entirely. Once the grantor passes away, the trust is set in stone and cannot be altered.
On the other hand, an irrevocable trust is set in stone once it becomes final. The grantor cannot change the beneficiaries, the terms, or remove assets from the trust once it is established.
These are the two main categories of trusts, but there are many other types of trusts you may encounter. These include:
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How are trusts taxed?
Trusts are taxed based on whether the trust’s distributions are principal or interest. Principal distributions, or distributions from the money originally placed in the trust, are not taxed. Interest payments, or distributions from the money earned in interest after the original money was placed in the trust, are taxed as income or as capital gains, depending on how they are earned.
Income tax rates for trusts range from 10% to 37% in 2023, depending on income level. Long-term capital gains are taxed at a rate between 0% and 20%, based on total profits.
Trusts and their beneficiaries will use IRS Form 1041 and a K-1 to file taxes. The K-1 indicates how much of the payment was interest and how much was principal.
Another factor that determines how trusts are taxed is whether the trust is a grantor trust or a non-grantor trust. Grantor trusts are set up so that the grantor pays taxes on the income. When it comes to non-grantor trusts, who pays taxes will depend on how the trust is set up. Trust accounting rules can be extremely complex, and your own personal financial situation outside the trust can also come into play.
What a trust inheritance tax might look like
Suppose you receive a $10,000 benefit for a year. When the trust sends you the K-1, you will see that $8,000 belonged to the principal. The IRS assumes this money has already been taxed, so you won’t owe tax on that amount. $1,000 comes from interest earned; You owe income tax on that amount. The last $1,000 came from selling shares at a profit; You owe capital gains tax on that amount.
In this example, you owe nothing on the $1,000 you make from selling a stock, assuming the stock has been held for at least a year. You will owe 10% interest on the amount earned, for a total of $100 in taxes.
This is a simple example, and as mentioned above, trust taxes can often become much more complicated. Work with the trustee or a personal financial advisor to ensure you get the right information.
A financial advisor can help you navigate the complications of trusts and other estate planning tools. Make a match with a fiduciary advisor today.
In short
Beneficiaries of a trust are typically taxed only on the income portion of their distributions, and whether that income is taxed as income or as capital gains depends on how it is earned. Who pays these taxes depends on how the trust is set up.
Estate planning tips
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Estate planning can be complicated, so it pays to be prepared. A financial advisor can be a solid resource to lean on. Finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Estate planning can be complex, and this is especially true if you are someone with significant assets. To make sure you have everything you need, read up on the essential wealth planning tools for high net worth investors.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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