When creating an estate plan, using a trust is a way to make passing on assets — including cash and physical assets — a little easier. In fact, when you use a trust, you can often allow your family to avoid the lengthy probate process after your death. Inheriting a trust comes with some tax implications. The rules can be complicated, but in general, only the fund’s earnings are taxed, not the principal.
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Trust basics
A trust is simply a legal vehicle that can be filled with a myriad of assets, including cash and physical property. The person who creates the trust is known as the grantor. The trust is supervised by a trustee. A trustee can be a person or a company that manages the trust for the benefit of the beneficiary. The beneficiary of the trust is the person who benefits from the assets. This beneficiary can be an individual, such as a child or other relative, or an organization such as a charitable group.
Trusts are often used as a tool to reduce estate taxes. Also, while assets transferred through a will usually must go through the probate process, trusts can usually bypass this step, speeding up the process and saving on court fees.
Types of trust funds
There are quite a few types of trusts, but one of the biggest differences between trusts is whether they are revocable or non-revocable. A revocable trust can be modified at any time during the life of the person providing the trust — also known as the grantor. The grantor can add or remove beneficiaries, add or remove assets from the trust, or terminate the trust entirely. Once the grantor dies, the trust is fixed and cannot be changed.
On the other hand, an irrevocable trust is drawn up once it is finalized. The grantor cannot change the beneficiaries, the terms, or remove any assets from the fund once it has been created.
These are the two main categories of trust funds, but there are Many other types of trust You may also come across. These include:
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How are trust funds taxed?
Trust funds are taxed based on whether the distributions from the fund are principal or interest. Principal distributions, or distributions taken from the money originally placed in the trust, are not taxed. Interest distributions, or distributions taken from money earned in interest after the original money has been deposited into the trust, are taxed either as income or income. capital gainsdepending on how they are earned.
the Income tax rates for trusts It ranges from 10% to 37% in 2023, depending on income level. Long-term capital gains are taxed at between 0% and 20%, based on total gains.
The trusts and their beneficiaries will use the IRS Form 1041 and a K-1 to file taxes. The K-1 will indicate how much interest was distributed and the principal amount.
Another factor that governs how trusts are taxed is whether the trust is a grantor or a non-grantor. The giver trusts They are set up so that the grantor pays taxes on the income. When it comes to non-grantor trusts, who pays the taxes will depend on how the fund was set up. Trust accounting rules can be quite complex, and your personal financial situation outside of the trust can also play a role.
What might a trust inheritance tax look like?
Let’s say you receive a $10,000 distribution for one year. When the trust sends you a K-1, you see that $8,000 was from the principal. The IRS assumes that this money has already been taxed, so you are not taxed on that amount. The amount was $1,000 in interest earned, and you will owe income tax on that amount. The last $1,000 was to sell the stock for a profit, and you’ll owe capital gains tax on that amount.
In this example, you would owe nothing for the $1,000 gained from the sale of the stock, assuming it was held for at least a year. You will owe 10% on the resulting amount of interest, for a total of $100 due in taxes.
This is a simple example, and as mentioned above, trust taxes can often get more complex. Work with your trustee or personal financial advisor to make sure you get the correct details.
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Trust fund beneficiaries are usually taxed only on the profits portions of their distributions, and whether those profits are taxed as income or capital gains depends on how they were earned. Who pays these taxes depends on how the fund was set up.
Estate planning tips
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Estate planning can be complicated, and this is especially true if you are someone with great wealth. To make sure you have everything you need, read what is essential Estate planning tools for wealthy investors.
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