Taxes. You can’t turn around without being taxed for something. We’re always looking for ways to avoid paying them. Having a Trust, a key component of an estate plan, may provide some tax savings to estates and beneficiaries. Let’s explore the tax implications of creating a Trust.
Trusts and Taxes
A Trust is a great vehicle to ensure your assets will pass directly to the beneficiary you name when you pass away. It not only sidesteps the probate process, but also may help to reduce – or even avoid – estate, gift, inheritance, and income taxes.
When you create a Trust, you – known as the Grantor or Settlor – take assets out of your estate (and your ownership) and place them in the Trust. The Trust now owns them. You appoint a Trustee to oversee the Trust who holds the assets on behalf of the beneficiaries you named. Upon your passing, the assets go right to the beneficiaries.
Since Trusts are legal entities, they are taxed differently than investment accounts. Interest and dividends from those accounts are subject to taxes.
While distributions from the Trust’s income are taxable, distributions from the Trust’s principal are not.
The principal in a Trust is an asset, such as stocks, cash, bonds, or property. Income is money generated by the asset: interest or dividends from investments or rental monies from real estate.
So, if a beneficiary is receiving distributions from the principal, it is not subject to taxes. However, if the beneficiary is receiving distributions from the income, it is taxable.
Learn More: Tax Implications of Estate Planning
Types of Trusts and the impact on taxes
When it comes to whether a Trust is subject to taxes, it depends on the type of Trust you have. Here is a look at several types of Trusts and the implications related taxes may have for beneficiaries or the estate:
- Simple Trust – This is a Trust where all generated income must be distributed at least once a year and no distributions of the principal are made. It cannot have charities as beneficiaries. Capital gains – or income earned in the Trust – is subject to tax and must be reported by the Trustee and paid through the Trust. It has a $300 tax exemption.
- Complex Trust – As with the Simple Trust, a Complex Trust’s income is taxable and paid by the Trust. However, this Trust can make deductible gifts to charities, must retain some of its income, and must distribute some of its principal to beneficiaries. It has a $100 tax exemption.
- Grantor Trust – The person who placed the assets into this Trust is known as the Grantor, who does not have to be the creator of the Trust. The principal – assets – is not subject to tax, but any income is. Income earned by the Trust is taxed to the Grantor and is reported on the Grantor’s personal income tax return. Also, the Grantor can amend the Trust and provide distributions to their spouse.
- Revocable Trust – Similar to a Grantor Trust, any income generated by this Trust is taxable to the creator and not the Trust. This Trust can be changed at any time by the Grantor who has control over the assets.
- Irrevocable Trust – Once this Trust is created, it cannot be changed or dissolved, and assets are no longer under control of the Grantor. Income in this Trust is taxable to the Trust, and the Trustee must file a tax return.
- Generation Skipping Trust – This allows you to distribute assets to your grandchildren or great grandchildren or anyone less than 37-1/2 years younger than you and bypass the federal estate tax or a generation skipping tax. The estate tax only affects distributions of more than $11.7 million ($23.4 million for a couple) as of 2021. Only about 1% of estates in this country pay an estate tax.
- Crummey Trust –To avoid paying a federal gift tax, parents can set up a Crummey Trust to provide their children with an annual gift of up to $15,000. The beneficiary must have immediate access to the funds after they are transferred into the Trust. However, the beneficiary does not actually have to withdraw the funds, just be allowed access to them within a certain period of time, typically 30 days. In this case, the funds can remain in the Trust and be distributed according to the time frame and terms you set.
- Credit Shelter Trust – Typically created by wealthy couples to avoid or minimize estate taxes for their children when they inherit their parents’ assets. When one spouse dies, the decedent’s assets go into the Credit Shelter Trust and overseen by a Trustee. When the surviving spouse passes, the assets transfer to the named heirs.
- Irrevocable Life Insurance Trust (ILIT) – This Trust owns one or more life insurance policies and upon your death, the benefits are paid to the Trust that are exempt from your taxable estate. Beneficiaries then can draw the proceeds.
Filing tax returns for Trust income
Trustees of Trusts subject to taxation must file IRS (Internal Revenue Service) Form 1041. Taxes must be paid on any interest earned on the principal if it is not distributed by the end of the year.
If a beneficiary receives a disbursement, the Trustee must file IRS Form K-1 that lists the disbursements and how much is from interest or principal. The beneficiary receives a copy of this form, which shows how much is taxable income.
Estate taxes and inheritance taxes
An estate tax is paid by the estate upon transfer of assets. An inheritance tax is paid by the heir or beneficiary when they receive their bequests.
As mentioned, the estate tax is a federal tax imposed only if the estate’s assets being transferred are valued at more than $11.7 million. Not to worry, though; only a handful of people are affected by this tax. Beginning Jan. 1, 2026, the tax exemption could be reduced to its original $5.49 million limit, still well above most people’s estate values. Surviving spouses typically are exempt from the estate tax. Also, even though you might be exempt from a federal estate tax, you may still have a state estate tax.
Learn More: Tax Implications of Estate Planning
The inheritance tax is determined by exemptions and the relationship of the beneficiary to the decedent. The tax is based on a scale of 1% to 18% of the inheritance. There are exemptions, ranging from up to $500 to $25,000. Immediate family – including surviving spouses, children, siblings, and charities – are generally exempt or pay only on a percentage of the inheritance.
Just six states have an inheritance tax: Kentucky, Maryland, New Jersey, Iowa, Pennsylvania, and Nebraska. Maryland has both the estate and inheritance tax.
Create your Trust with Gentreo
You can create, store, and share your Trust and estate planning documents with Gentreo to protect yourself, your wishes, and your loved ones. Along with your estate plan, you can also store important documents such as your digital assets, medication list, physician information, and insurance policies in the Gentreo Digital Vault, which can be accessed anytime from anywhere.