Financial advisors should counsel their clients on the issues related to irrevocable trusts, as these tend to be complex.
When a grantor makes a transfer into an irrevocable trust, the individual essentially gives up their rights of ownership of the assets and the trust becomes a separate taxable entity, says Anjali Jariwala, founder of FIT Advisors in Chicago.
The trust may be subject to the 3.8% net investment income tax, which is triggered at relatively low levels for trusts by comparison with individuals, she says.
The threshold for the 3.8% surtax is $250,000 for a married couple but just $12,300 for a trust.
“Although the trust threshold is indexed for inflation, unlike the threshold for individuals, the level is still very low,” Jariwala says. “It is very easy for the income in the trust to reach the threshold amount.”
One way to mitigate the tax impact is to distribute the income out of the trust to avoid the 3.8% surtax, Jariwala says.
Assume that Trust A has $100,000 of interest and dividend income and $200,000 of capital gains. If the trust makes no distributions, the net investment income subject to surtax will be $287,700 ($300,000 income, less the $12,300 threshold).
If the beneficiary of the trust is an individual with adjusted gross income of $50,000, the trust can distribute the interest and dividend income of $100,000, Jariwala says.
The individual won’t be subject to the surtax because his income of $150,000 is below the threshold for an individual at $200,000, and the trust will avoid the surtax on $100,000 of its income.
Irrevocable trusts have to file their own tax returns on Internal Revenue Service Form 1041 instead of a 1040, says David D. Holland, chief executive and planner at Holland Financial Inc. in Ormond Beach, Fla.
An irrevocable trust is subject to the same tax breaks as an individual, but the difference between brackets is very short, he says.
A trust can get to the highest bracket of 39.6% with just $12,301 of taxable income this year, while a married filing jointly couple would need more than $464,850 to be in the same bracket.
“The tax law is written in a way to encourage individuals or families with these trusts to disburse the income out to the trust beneficiaries who then pay tax on it. Given the difference in tax treatment, it’s often better to be taxed at the individual level and not at the trust level,” Holland says.
Katie Kuehner-Hebert is a freelance writer in Running Springs, Calif. She has contributed to American Banker, Risk & Insurance and Human Resource Executive.
This is part of a 30-30 series on tax planning strategies.