Tax increases for the affluent have dominated headlines this year. But don’t overlook the impact of higher taxes on trusts. The income thresholds for trusts are extremely low, so it’s important for taxpayers at all income levels to consider the potential impact on their estate plans.
Changes to rates
For 2013, the top marginal individual income tax rate is 39.6% (up from 35%). And the capital gains rate for taxpayers in the highest bracket is 20% (up from 15%). High earners are also now subject to a 3.8% tax on net investment income — including interest, dividends, annuities, rents, royalties, net capital gains and certain passive business income. The income levels at which these tax increases apply vary.
This year, trusts are subject to the 39.6% ordinary income rate and the 20% capital gains rate to the extent their taxable income exceeds $11,950. And the 3.8% investment tax applies to undistributed net investment income to the extent that a trust’s adjusted gross income exceeds $11,950.
3 ways to soften the blow
Three strategies can help you soften the blow of higher taxes on trust income:
1. 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, using an IDGT won’t avoid the tax increases described above. Still, the other benefits of these trusts make them very attractive.
2. 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.
3. 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 avoiding income, capital gains and investment taxes is to distribute trust 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.
A helpful review
This year, many trusts will be subject to higher taxes. Ask your tax advisor for help reviewing your estate plan. Doing so may very well reveal opportunities to reduce your family’s tax burden.