Trusts and Tax Rates: Some Notable Considerations
Trusts are a legal entity that is commonly used to hold assets for future distribution or management purposes. For example, it is common for some families to create a trust to fund their children’s college education, contributing funds that the children can later withdraw to pay their college expenses while going to school. It is also common to place the family home and assets into a trust that will own the property, potentially indefinitely, to ensure the home, its furnishings, and additional assets always stay within the family. Trusts and taxes can become very complicated, however. To be certain that you make good decisions, it is advisable that you work with a team that specializes in this area to help clarify relevant issues, such as a financial advisor, CPA, and an attorney.
What is a Trust?
There are many types of trusts. This article is not intended to discuss all possible options, but I will discuss three main kinds of trusts plus a specific scenario using an additional type.
- Simple Trusts are the most basic and common trusts. They hold assets and distribute all annual income to the beneficiaries. However, the original principal is not distributed.
- Complex Trusts, or “not a simple trust”, are considered complex if they distribute less than all of their earned income annually; if they distribute any principal; or if distributions are made to charities as well as named beneficiaries.
- Grantor Trusts are managed by the individual who established the trust.
With a grantor trust, the individual who established the trust pays all related taxes. For simple and complex trusts, however, taxes are paid by the trusts themselves on all income, assets, and tax events.
Trusts may be subject to federal, state, and local taxes. However, it would be well beyond the scope of this article to discuss all possible state and/or local taxation requirements, so I will only discuss federal tax rates and exemptions in this article.
2024 Ordinary Income Trust Tax Rates
In 2024, the federal government will tax trust income at four levels. These tax levels apply to all income generated by estates as well. The following table displays the ranges and rates.
| Income Range | Tax Rate |
|---|---|
| $0 - $3,100 | 10% |
| $3,100 - $11,150 | 24% |
| $11,150 - $15,200 | 35% |
| >$15,200 | 37% |
2024 Long-Term Capital Gains Trust Tax Rates
Short-term capital gains from assets held for 12 months or less, and non-qualified dividends, are taxed according to ordinary income tax rates listed above. Qualified dividends and capital gains on assets held for more than 12 months are taxed at a lower rate called the long-term capital gains rate. For trusts, there are three long-term capital gains brackets. The brackets and corresponding tax rates are listed in the table below.
| Capital Gains Range | Tax Rate |
|---|---|
| $0 - $3,150 | 0% |
| $3,150 - $15,450 | 15% |
| >$15,450 | 20% |
Once again, these tax brackets also apply to estates as well. Many trusts generate most of their income through investments, but that is not always the case. Many trusts manage assets such as buildings and other property that generate rental income. While appreciation of these properties is classified as capital gains, the rental fees generated by these properties are income, not capital gains, and must be taxed as such.
As you can see from the above tables, trusts are taxed far more aggressively than individuals. However, proper tax planning can greatly reduce, or potentially eliminate, most of these taxes.
Primary Tax Deductions for Trusts
There are several tax deductions that a trust might qualify for. The following four categories are the most common deductions that apply to trusts.
Gifts and Contributions
The contributions made to a trust are typically non-taxable because the contributor has already paid taxes on the money, so the IRS considers this double taxation. As such, the trust only pays taxes on income it generates from money and assets it holds.
The trust beneficiary may have to pay taxes on distributions that he or she received from income that the trust earned in the current tax year. A beneficiary does not have to pay taxes on any distributions that the trust makes from the principal balance, however, to avoid double taxation. Again, this is because the money in the trust’s principal has already been taxed. Additionally, any money that the trust earns and distributes in the same year, it does not pay taxes on.
However, in some cases, a beneficiary can avoid paying any taxes if he or she has received less from the trust than the lifetime gift tax exemption. In 2024, that is set at $13.61 million for individuals, and $27.22 million for couples.
Trustee and Tax Preparation Fees
The trust may deduct reasonable fees for trustee management and tax preparation. However, the fee deductions are limited to the proportion of income that is taxable. Assuming that the trust earned $50,000 of income in a given year, but only $30,000 is taxable, then only 60% of the fees are tax deductible.
Charitable Donations
A trust may typically deduct any cash donations made to charity. However, a trust cannot deduct more in donations that what it earned in taxable income in the given year.
Income Distribution Deductions
Trusts that make distributions to beneficiaries can separate their income into two categories for tax purposes. The portion of the income that the trust distributes is known as distributable net income, or DNI. DNI is subtracted from the portion of the income which the trust keeps for itself.
Trusts do not have to pay taxes on the portion of their income that they distribute to beneficiaries in the same calendar year as it was earned. This is because beneficiaries pay taxes on the income. Any income that the trust does not distribute in the same year that it is earned is taxed and then added to the trust’s principal.
One Final Trust Type: What Is a Testamentary Trust?
A testamentary trust is a specific type of trust that is created as part of a last will and testament. A grantor (the creator of the trust) leaves instructions in their will for a named executor detailing how their assets are managed by a trustee and distributed to beneficiaries. The trust itself is established after the grantor's death.
Creating a testamentary trust for minor children, relatives, or others who may inherit estate assets is most common. In their will, a grantor can create separate trusts for each beneficiary, which splits assets equally, or a family trust allowing assets to be distributed based on a beneficiary’s need.
How do testamentary trusts work?
After the grantor’s death, the probate court verifies the will is authentic before the trust can be established. A document called a letters testamentary, which provides court authorization to the will’s executor, is usually required — along with a death certificate — for the trust to be established.
Once authorized, the executor establishes the testamentary trust, and the trustee manages the deceased’s assets on behalf of the beneficiaries. Often, assets can’t be distributed to beneficiaries until predetermined conditions are met. This might be when young children turn a certain age, or, for special needs children, it may mean that they only receive a limited stipend.
For example, if an adult child requires constant care and receives Social Security Disability or Medicaid benefits, directly inheriting assets from a deceased parent could potentially cause the beneficiary to lose government care and benefits. In this case, creating a testamentary trust allows for a deceased parent to continue to provide support for their child without causing them to entirely lose government care and support that they might have been receiving for decades.
A testamentary trust lasts until the terms of the trust expire and the assets are distributed to the beneficiaries.
Final Thoughts
Trusts have become a much more common estate planning tool in recent years. Trusts may solve a host of estate planning problems if planned and executed properly. Or they may create several unintended consequences if all the ramifications are not properly considered and accounted for. It is important to understand this if you are thinking about opening a trust or managing your trust without professional help. Due to their complexities, however, it’s advised that you work with a financial advisor, and his or her team, that can help you through the process and make sure your trust takes the proper deductions and pays the necessary taxes.
