Trusts are legal entities created to hold and manage assets for the benefit of beneficiaries. While trusts can provide several advantages, such as asset protection and estate planning, they can also be subject to higher taxes than individual taxpayers.
How Trusts Are Taxed
Trusts are taxed differently depending on their type and the distribution of income and principal. There are two main types of trusts:
- Grantor trusts: The grantor, or creator, of the trust maintains control over the assets and is responsible for paying taxes on the trust’s income.
- Non-grantor trusts: The trust is considered a separate tax entity and is responsible for paying taxes on its income.
Non-grantor trusts are further classified as either simple or complex:
- Simple trusts: All income must be distributed to beneficiaries each year, and no distributions of principal are allowed.
- Complex trusts: The trustee has discretion over the distribution of income and principal.
The tax treatment of trust income depends on the type of trust and the distribution of income and principal. In general, income distributed to beneficiaries is taxed at the beneficiary’s income tax rate. However, if the trust retains income, it is taxed at the trust’s income tax rate, which is higher than the individual income tax rate.
Why Taxes Are So High on Trusts
There are several reasons why trusts are subject to higher taxes than individual taxpayers:
- Compressed tax brackets: Trusts reach the highest federal marginal income tax rate at much lower income levels than individual taxpayers. For example, in 2023, trusts reach the 37% tax bracket at $13,450 of taxable income, while individual taxpayers reach the same bracket at $539,900.
- No standard deduction or personal exemption: Trusts are not entitled to the standard deduction or personal exemption that individual taxpayers can claim. This means that trusts pay taxes on a larger portion of their income.
- Accumulated income: Complex trusts can accumulate income and pay taxes on it at the trust’s higher tax rate. This accumulated income is then distributed to beneficiaries, who must pay taxes on it again at their own income tax rate.
Strategies to Reduce Trust Taxes
There are several strategies that can be used to reduce trust taxes, including:
- Distributing income to beneficiaries: By distributing income to beneficiaries, the trust can avoid paying taxes on that income at the trust’s higher tax rate.
- Investing in tax-efficient assets: Trusts can invest in tax-efficient assets, such as municipal bonds, to reduce their overall tax liability.
- Using a charitable remainder trust: A charitable remainder trust allows the grantor to make a gift to charity while retaining a life interest in the trust. The trust is then taxed at a lower rate, and the charitable remainder is eventually distributed to the charity tax-free.
Trusts can be a valuable tool for asset protection and estate planning, but they can also be subject to higher taxes than individual taxpayers. By understanding the tax implications of trusts and using strategies to reduce taxes, you can maximize the benefits of a trust while minimizing the tax burden.
FAQs
Q: Why are trusts taxed so high?
A: Trusts are taxed at higher rates than individual taxpayers due to compressed tax brackets, no standard deduction or personal exemption, and the accumulation of income.
Q: How can I reduce trust taxes?
A: Strategies to reduce trust taxes include distributing income to beneficiaries, investing in tax-efficient assets, and using a charitable remainder trust.
Q: What is a grantor trust?
A: A grantor trust is a trust in which the grantor maintains control over the assets and is responsible for paying taxes on the trust’s income.
Q: What is a non-grantor trust?
A: A non-grantor trust is a trust that is considered a separate tax entity and is responsible for paying taxes on its income.
Q: What is a simple trust?
A: A simple trust is a non-grantor trust that must distribute all income to beneficiaries each year and cannot distribute any principal.
Q: What is a complex trust?
A: A complex trust is a non-grantor trust that gives the trustee discretion over the distribution of income and principal.
How Do Trusts Get Taxed? Basics of Trust Taxation & Can They Pay No Tax?
FAQ
How can I reduce my trust taxes?
Do trusts pay higher taxes?
Do you have to pay taxes on money inherited from a trust?
What is the best trust to minimize taxes?
Do trusts pay higher income taxes?
Trusts reach the highest federal marginal income tax rate at much lower thresholds than individual taxpayers, and therefore generally pay higher income taxes. The income tax treatment of different types of trusts can vary meaningfully. Structuring trusts so they distribute income to beneficiaries may be an effective way to help reduce income taxes.
Are trusts taxed more aggressively than individuals?
While the maximum rates are the same for a trust and an individual, trusts are taxed more aggressively than individuals. Consider that in the 2024 tax year, the top marginal tax rate for a single filer, 37%, begins after $609,350 of ordinary income. A trust is subject to that rate after reaching only $15,200 of income.
Should you sell a trust if you have a high income tax?
Make it part of your investment analysis. If the trust receives income sourced to a high tax state, you need to factor the state income tax impact into the trustee’s evaluation of the investments. In some cases, that may be enough to consider selling the investment or looking for an alternative.
How is a trust taxed?
There are complex trust accounting rules that govern the treatment of a trust’s income, expenses, taxes, and distributions. For income tax purposes, a trust is treated either as a grantor or a non-grantor trust.