People often come to us curious – or confused – about the role trusts play in saving on taxes. Given how frequently this issue comes up, here we’re going to explain the tax implications associated with different types of trusts to clarify this issue. Of course, if you need further clarification about trusts, taxes, or any other issue related to estate planning, meet with us for additional guidance.
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 the most commonly used form of trust in estate planning. And as long as you are living, there is no tax impact on 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 to avoid 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 that 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 if you become incapacitated or die. At that point, the trustee you’ve named will step in and take over the management of the trust assets, and one of the first things that your trustee will do is 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).
IRREVOCABLE TRUSTS
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 created during your lifetime, the trust is a separate tax-paying entity. It is either subject to income tax on the earnings of the trust at the rates of the trust or 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, and your chosen trustee takes total control of the assets transferred into the name of the trust. Because you no longer own the assets the trust holds, those assets are no longer considered part of your estate. As long as the trust has been properly maintained, the assets held by the trust are 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, typically much lower.
We often set up a trust in this way when creating a Lifetime Asset Protection Trust for a beneficiary. When set up like this, the trust can provide the beneficiary with protection from common life events, such as serious debt, divorce, debilitating illness, crippling accidents, lawsuits, and bankruptcy, without being taxed at such a high rate on such little income.
If you have a trust set up and would like us to review its income tax consequences for your loved ones upon your death, meet with us, your attorney.
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 death. Upon your death, if the total value of your estate is above a certain threshold amount, known as the federal estate tax exemption, the IRS requires your estate to pay a tax, known as the estate tax, before any assets can be passed to your beneficiaries.
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.
You can reduce your estate tax liability – or even eliminate it together – by using various estate planning strategies. Most of these strategies are fairly complex and involve the use of irrevocable trusts, but such strategies are without question worth it if you can save your family such a massive tax bill. To learn how to save your family from such a major tax burden, meet with us to discuss your options.
And please note we are only speaking about the federal estate tax here. Currently, 12 states have their own estate tax, which is separate from the federal estate tax. We’ll cover the specifics of what happens in our state regarding your estate tax when we have a Family Wealth Planning Session. Give us a call to schedule yours if you have not yet had a Planning Session with us.
THE FUTURE ESTATE TAX
The current $12.06 million 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 us, we will ensure that we 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.
WE’RE HERE FOR YOU
If you are trying to decide whether a revocable living trust, irrevocable trust, Lifetime Asset Protection Trust, or some other estate planning vehicle is the right solution for you and your family, meet with us, your attorney. We 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. Call us today to schedule your visit.
At Cheever Law, APC, we don’t just draft documents; we ensure you make informed and empowered decisions about life and death for yourself and the people you love, starting with a valuable and educational Family Wealth Planning Session. The Life & Legacy Planning Session will allow you to get more financially organized and make the best choices for the people you love. If you have already completed your estate plan, we will review that plan at your Life & Legacy Planning Session (aka Family Wealth Planning Session) to ensure that it will work the way you intend and address any holes or gaps that may be present if circumstances have changed since you executed your plan.
To learn more about our one-of-a-kind systems and services, contact us or schedule a 15-minute introductory call today.